Transcript Lecture 8
L11200 Introduction to Macroeconomics 2009/10 Lecture 8: Markets, Prices, Supply and Demand I 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 d d Y A f (K , L ) – 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) 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 PY ( wLd RK d ) P( A f ( K d , Ld ) (wLd RK d ) – Wage wL – Income from leasing capital: i ( PK ) – Interest on savings (bonds): i ( B ) Household Spending • Spending: Consumption, Investment, Bonds – Consumption: PC – Investment in new Capital: P K – Investment in new bonds: B – 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 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: PC B P K wL i ( B PK ) 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 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: C (1/ P) B K / P ( w / P) L i ( B / P K ) • This will become relevant when we consider how changes in the money supply affect prices • For the time being money supply is fixed. 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..