Lecture 8: Markets, Prices, Supply and Demand I
L11200 Introduction to Macroeconomics 2009/10
Reading: Barro Ch.6 11 February 2010
Introduction
• Last time:– Finished the Economic Growth topic by
considering ‘Long-Run Growth’– Continuous technological progress most
convincing explanation for long-run growth
• Today– Begin topic on fluctuations– Set foundations for model of fluctuations
Fluctuations
• Why fluctuations matter• Cyclical pattern in GDP growth matched by
cyclical pattern in:– Employment, Unemployment and hours of work– Consumption Spending and Investment– Inflation and price movements– Interest rates– Government Spending and Debt
Modelling Fluctuations
• To model these we need a model in which agents make choices over– Hours of work, and work/non-work choice– Consumption now versus saving for later– Investing now versus taking profits– Government spending and taxation
• So need model in which microeconomics of consumers, firms and governments are joined together
Basic Model Setup
• Basic element in the model is the ‘household’– Owns a small business: uses capital and labour to
produce output– Supplies labour (to itself, and maybe to others)– Owns capital (and can also rent / lease capital)– Earns profit, which it consumes / saves in bonds
• Assume households are price takers, i.e. perfectly competitive markets
Perfect Competition
• So economy is populated by perfectly competitive firms– Implies profit will equal 0 in equilibrium– Do not model monopolistically competitive /
monopoly / oligopoly firms in the economy (yet)– But have now connected the firm to the
household: also a consumer and a supplier of labour and an owner of capital.
Household Activities
• Households:– Produce output via the production function
– They employ themselves and then hire extra labour / sell their extra labour if they want to
– They own some capital K, and hire extra capital / lease extra capital if they want to
– Initially assume that the supply of L and K is perfectly inelastic: all labour and machines are used all of the time (will relax this later)
( , )d dY A f K L
Household Activities
• They use their profit + wage income + rental income to:– Consume: only non-durable goods consumed– Invest: buy more capital for production– Save: save their income in a risk-free bond (i.e. a
savings account)– Return on bond = marginal product of capital.
Prices
• Households produce an output which can either be invested, sold or consumed– Each unit of output can be sold at a price P– Value of consumption = C (number of units
consumed) x P (price per unit)– Value of investment = K (number of units of
capital bought) x P (price per unit)– So the price level P applies to both one unit of
consumption and one unit of capital
Household Income
• Income components: profit, wage, rent, return on savings (income from bonds)– Profit = income from sales – wage – rent
– Wage – Income from leasing capital:– Interest on savings (bonds):
( )d dPY wL RK
( ( , ) ( )d d d dP A f K L wL RK wL
( )i PK
( )i B
Household Spending
• Spending: Consumption, Investment, Bonds– Consumption:– Investment in new Capital: – Investment in new bonds:– So if investment in new bonds is negative, the
household is spending their savings (i.e. B is reduced to fund either consumption or buying new capital)
– The value of bonds is a monetary value
PC
P KB
Money Holding
• Missing element is ‘cash’ money– Money in our economy is ‘paper money’: a
medium of exchange which can be used to buy output, capital, bonds and pay wages (to labour) and rent (to capital).
– Household money demand is constant (relax this later)
– Total quantity of money is economy is constant (relax this later)
Budget Constraint
• Now we can put together the household budget constraint:
nominal consumption + nominal saving = nominal income
( )PC B P K wL i B PK
(price per unit of consumption x number of units consumed) + change in value of bonds + new spending on capital = profit from the household business + wages earned supplying labour to the household business or others + rent earned leasing capital to the household business or others
What is this?
• A budget constraint is an accounting equation which describes the limits of the household activities:– The right-hand side is income– The left-hand side is spending (including spending
savings)– So the two sides must match! This equation has to
balance each and every period
Budget Constraint in Real Terms
• To find budget constraint in real terms, divide all nominal values by P:
• This will become relevant when we consider how changes in the money supply affect prices
• For the time being money supply is fixed.
(1/ ) / ( / ) ( / )C P B K P w P L i B P K
Household Behaviour
• The budget constraint describes household income / expenditures. Questions now are:– How much does household choose to:– Consume– Save in bonds– Invest in new capital– Produce– (note we assume L is fixed: household will always
work constant hours)
Summary
• Have built the basics of the macroeconomy– Basic unit is the producing, consuming, labour
supply, capital holding, household– Described the household activities and sources of
income / types of expenditure
• Next time: begin modelling behaviour– Consider how much the household produces (and
so how much labour and capital they use)– Then consider what they do with their income..