1. Lecture 8: Markets, Prices, Supply and Demand I L11200 Introduction to Macroeconomics 2009/10 Reading: Barro Ch.6 11 February 2010

2. 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

3. 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

4. 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

5. 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

6. 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.

7. 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)

8. 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.

9. 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

10. 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):

11. 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

12. 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)

13. Budget Constraint Now we can put together the household budget constraint: nominal consumption + nominal saving = nominal income (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

14. 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

15. 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.

16. 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)

17. 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..