1. Chapter 6 Markets, Prices, Supply, and Demand

2. Objective: understand short-run economic fluctuations. Micro foundations: the choices made by consumers and firms.  Supply and demand behavior. The neoclassical way: the market clears.

3. Timing States: B t-1, K t-1, P t-1, M t-1  They are values at the end of period t-1, or at the beginning of period t.  They are real or nominal assets at the end of period t.

4. Timing Economic agents (period t)  Firm: Y t =A t F(K t-1, L t );  Consumer: U(C t, 1-L t );  Both are price-takers. Markets (period t)  Rental market: R t-1 ;  Bonds market: i t-1 ;  Labor market: w t ;  Money market: P t.

5. Timing Controls: C t, L t, B t, K t,  They are household’s decisions based on observed prices and real assets;  Real assets include interest and rental income paid in period t. States at the end of period t: B t, K t, P t, M t

6. Markets in the Macroeconomy Direct ownership of firms: no stock market. The goods market: nothing peculiar. The labor market  Inelastic supply of labor: L s =L t ;  L d determined by firms’ behavior. The rental market  Inelastic supply of capital: K s =K t-1 ;  K d determined by firms’ behavior.

7. Markets in the Macroeconomy The bond market: borrowing between households. The money market  Inelastic supply of money: M s =M t ;  Household demands m d =M d /P t.

8. Money as a Medium of Exchange All exchange uses money. Dollar amounts are nominal terms. Money earns no interest.

9. Markets and Prices The money market  The general price level: P t. The labor market  Nominal wage: w t.  Real wage: w t /P t.

10. Markets and Prices The rental market  Nominal rental price: R t-1.  Real rental price: R t-1 /P t.  Nominal rental income (payment): R t-1 K t-1. The bond market  Nominal interest rate: i t-1.  Nominal interest income: i t-1 B t-1.  In aggregation, the net borrowing must be zero.

11. The Budget Constraint Nominal income  Profit:  t =P t A t F(K t-1, L t )-(w t L t +R t-1 K t-1 )  Wage income: w t L t.  Rental income: R t-1 K t-1. Net nominal rental income: R t-1 K t-1 -  P t K t-1. Rate of return: R t-1 /P t - .  Interest income: i t-1 B t-1.  Total income:  t +w t L t +(R t-1 /P t -  )P t K t-1 +i t-1 B t-1.

12. The Budget Constraint Nominal rates of return from t-1 to t:  On bonds: i t-1 ;  On capital: ; Real rates of return from t-1 to t:  On bonds: ; The Fischer equation:  On capital:.

13. The Budget Constraint Nominal consumption: P t C t. Assets  Capital, bonds, and money.  Nominal income from holding money: zero.  Capital and bonds must yield the same real rates of return.  The nominal income can be put as  t +w t L t +r t-1 P t K t-1 +i t-1 B t-1 =  t +w t L t +r t-1 P t K t-1 +((1+r t-1 )P t /P t-1 -1)B t-1

14. The Budget Constraint Household budget constraint  Nominal value of assets: M t-1 +B t-1 +P t K t-1.  Nominal saving:  M t +  B t +P t  K t  Budget constraint in nominal terms: P t C t +  B t +P t  K t +  M t =  t +w t L t +i t-1 B t-1 +r t-1 P t K t-1  Budget constraint in real terms:

15. The Budget Constraint The budget line

16. Market Clearing Profit maximization  The firm tries to maximize the real profit:  Assuming competitive behavior: price taker.  Maximize profit by choosing over K d and L d.

17. Market Clearing The labor market  Demand for labor: The production function exhibits diminishing marginal productivity in labor; The labor demand curve is downward sloping.  Supply of labor: L s =L t.  Market clearing:

18. Market Clearing Labor market clears

19. Market Clearing The Market for capital services  Demand for capital: The production function exhibits diminishing marginal productivity in capital; The demand curve for capital is downward sloping.  Supply of capital: K s =K t-1.  Market clearing:  The real interest rate:

20. Market Clearing Market of capital services clears

21. Market Clearing Zero profit at equilibrium

22. The budget constraint Budget constraint in nominal terms:  P t C t +  B t +P t  K t +  M t =w t L t +i t-1 B t-1 +r t-1 P t K t-1  P t C t +B t +P t K t +M t =w t L t +(1+i t-1 )B t-1 +(1+r t-1 )P t K t- 1 +M t-1  P t C t +B t +P t K t +M t =w t L t +(1+i t-1 )B t-1 +(R t-1 /P t +1-  )P t K t-1 +M t-1  P t C t +B t +P t K t +M t =P t A t F(K t-1, L t )+(1+i t-1 )B t-1 +(1-  )P t K t-1 +M t-1

23. The budget constraint Budget constraint in real terms:

24. Choice of future assets Future rates of return: i t and R t  They are determined by future market conditions; Future price level: P t+1  It is determined by future market conditions; Real rates of return:  (1+i t )P t /P t+1 -1 and R t /P t+1 -  ; The choice of B t and K t is based on expectations on future rates of return and future price level.

25. Real Business Cycle Money is left untreated:  Assume that M t =M;  Assume that P t =P;  It follows that i t-1 =r t-1. Household budget constraint:  PC t +  B t +P  K t =w t L t +i t-1 B t-1 +r t-1 PK t-1  PC t +B t +PK t =PA t F(K t-1, L t )+(1+i t-1 )B t-1 +(1-  )PK t-1