Markets, Prices, Supply, and Demand

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Chapter 6
Markets, Prices, Supply, and Demand
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Markets in the Macroeconomy

• Assuming that households perform all of the
  functions in the economy.
• Each household runs a family business and uses
  labor, L, and capital, K, to produce goods, Y,
  through the production function.
• Y A F( K, L)

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Markets in the Macroeconomy
Goods market
Households
Households (Firms)
Labor market
Rental market
Bond market
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The Goods Market

• Households sell all the goods they produce on a
  goods market. Then households buy back from this
  market the goods that they want.
• Household buys goods for
• consumption.
• to increase the stock of goods in the form of
  capital used for production, called investment.

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The Goods Market and Prices

• The price in this goods market, denoted by P,
  expresses the number of dollars that exchange for
  one unit of goods.
• We call P the price level.

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The goods Market and Prices

• Y A F( K, L)
• Since all of these goods are sold on the goods
  market, the variable Y will also represent the
• Quantity of goods per year sold and bought on the
  goods market.
• The quantity PY is the dollar value per year of
  the goods bought and sold on the goods market.

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The goods Market and Prices

• The expression 1/P is the value of 1 in terms of
  the goods that it buys.
• M dollars exchange for
• (M) (1/ P) M/P
• An expression like M/P is in real terms, in units
  of goods, whereas a quantity like M is in dollar
  or nominal terms.

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Labor Market in the Macroeconomy

• Households supply labor on a labor market.
• Assume that the quantity supplied, Ls, is a
  constant, L.
• Households buy and sell labor in the labor market
  at the dollar or nominal wage rate, w.
• The real wage rate is w/P.

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Rental Markets in the Macroeconomy

• Each household rents out all of the capital that
  it owns on a rental market.
• We think of the capital offered on the rental
  market as the supply of capital services, Ks.
  Since we have assumed that each household rents
  out all of its capital, we have Ks K.

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Rental Markets and Prices

• Households rent out capital, K, for dollars at
  the dollar or nominal rental price, R
• A household that rents the amount of capital Kd
  pays the nominal amount RKd per year and then
  gets to use the capital as an input to
  production.
• The real rental price is R/P.

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The Bond Market in the Macroeconomy

• A borrowing household receives a loan from
  another household, whereas a lending household
  provides a loan to another household.
• A household that makes a loan receives a piece of
  paper called a bond, and we call the market on
  which households borrow or lend the bond market.
  The holder of a bond, the lender, has a claim to
  the amount owed by the borrower.

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The bond Market and Prices

• Each unit of bonds commits the borrower to repay
  1 to the holder of the bond. This 1 is the
  principal of each bond.
• The principal is the initial amount advanced on a
  loan.

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The Bond Markets and Prices

• Each unit of bonds commits the borrower to pay
  the holder a flow of interest payments of i per
  year.
• The variable i is the interest rate, which is the
  ratio of the interest payment, i, to the
  principal 1.
• The interest rate, i, can vary over time.

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Money as a Medium of Exchange

• We assume that the exchanges on each of these
  markets use a single form of medium of exchange.
• A medium of exchange is an object held, not for
  its own sake, but rather to trade fairly soon for
  something else, such as goods and services. We
  call the medium of exchange in our model money.

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Money as a Medium of Exchange

• Assume that money is just a piece of paper,
  analogous to a paper currency issued by a
  government.
• Money is denominated in an arbitrary unit, such
  as a dollar.
• Dollar amounts are in nominal terms.
• Paper money earns no interest.

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Money as a Medium of Exchange

• The sum of the individual holdings of money
  equals the aggregate quantity of money in the
  economy.
• Assume, for now, that this aggregate quantity of
  money is a given constant.
• The total money held by all households must end
  up equaling this constant.

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Constructing the Budget Constraint

• The quantities and prices determined on the four
  markets will determine household income.
• Flows of income are sources of funds
• Purchases of goods and assets are uses of funds
• The total sources of funds must equal the total
  uses of funds. This equality is called the
  household budget constraint.

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Constructing the Budget Constraint

• Income
• Profits
• Households may earn profitan excess of revenue
  over costsfrom their business activities.
• Y A F( Kd, Ld )
• p PY - (wLd RKd)
• p P A F( Kd, Ld ) - ( wLd RKd)

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Constructing the Budget Constraint

• Income
• Wage income
• If households supply the quantity of labor Ls to
  the labor market, they receive the nominal wage
  income of wLs per year.
• Quantity of labor supplied is the fixed amount L,
  so nominal wage income is wL.

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Constructing the Budget Constraint

• Income
• Rental income
• If households supply the quantity of capital Ks
  to the rental market they receive the nominal
  rental income of RKs per year.
• Since households supply all of their available
  capital, K, to the rental market, so that Ks K,
  the nominal rental income is RK.

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Constructing the Budget Constraint

• Rental income
• The quantity dK of capital disappears each year.
  The dollar value of this lost capital is PdK.
• net nominal rental income nominal rental income-
  value of depreciation
• net nominal rental income RK-dPK
• net nominal rental income (R/P)PK-dPK
• net nominal rental income (R/P-d)PK
• Rate of return on owning capital R/P-d

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Constructing the Budget Constraint

• Interest Income
• If a households nominal bond holdings are B, the
  flow of nominal interest income received is iB
  per year.
• Since B equals zero for the whole economy, we
  have that the total of interest income equals
  zero.

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Constructing the Budget Constraint

• Total income
• Household nominal income nominal profit
  nominal wage income nominal net rental income
  nominal interest income
• Household nominal income pwL(R/P-d)PKiB

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Constructing the Budget Constraint

• Consumption
• Households consume goods in the quantity C per
  year at price P
• Household nominal consumption P C

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Constructing the Budget Constraint

• Assets
• Households hold assets in three forms
• money, M
• bonds, B
• ownership of capital, K.

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Constructing the Budget Constraint

• Assets
• We assume that households hold a fixed amount of
  money in dollar terms that is, we assume that
  the change over time of a households nominal
  money holdings is zero
• ?M0

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Constructing the Budget Constraint

• Assets
• In considering whether to hold assets as bonds or
  capital, households would compare the rate of
  return on bonds, the interest rate, i, with the
  rate of return on ownership of capital, R/P -d.
• Rate of return on bonds rate of return on
  ownership
• i R/P - d

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Constructing the Budget Constraint

• Household nominal income
• p wL i ( B PK )

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Constructing the Budget Constraint

• Household Budget Constraint
• nominal value of assets M B P K
• nominal saving to be the change over time in the
  nominal value of assets.
• nominal saving (?nominal assets)
• ?M ?B P?K

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Constructing the Budget Constraint

• Household Budget Constraint
• nominal saving nominal income- nominal
  consumption
• nominal saving p wL i ( B P K ) - P C
• ?B P ?K p wL i( B PK)-PC

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Constructing the Budget Constraint

• Household Budget Constraint in Nominal Terms
• PC ?B P?K p wL i( B PK )
• nominal consumption nominal saving nominal
  income

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Constructing the Budget Constraint

• Household Budget Constraint real terms
• C (1/P)?B ?K p/P (w/P)L i(B/PK)
• consumption real saving real income

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Constructing the Budget Constraint
34
Clearing of the Markets for Labor and Capital
Services

• Profit Maximization
• Real Profit
• p/P AF(Kd,Ld) - (w/P) Ld - (R/P) Kd
• real profit
• output - real wage payments - real rental
  payments

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Clearing of the Markets for Labor and Capital
Services
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Clearing of the Markets for Labor and Capital
Services

• The Labor Market
• Demand for labor
• ?(p/P) ? AF( Kd, Ld) - w/P
• MPL - w/P
• change in real profit marginal product of labor-
  real wage rate

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Clearing of the Markets for Labor and Capital
Services
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Clearing of the Markets for Labor and Capital
Services

• Supply of labor
• We are assuming that each household supplies a
  fixed quantity of labor to the labor market.
• Therefore, the aggregate or market supply of
  labor, Ls, is the given amount L.

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Clearing of the Markets for Labor and Capital
Services

• Clearing of the labor market
• w/P is determined to equate the aggregate
  quantity of labor demanded, Ld, to the aggregate
  quantity supplied, L.
• (w/P) MPL ( evaluated at L)

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Clearing of the Markets for Labor and Capital
Services
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Clearing of the Markets for Labor and Capital
Services

• The Market for Capital Services
• Demand for capital services
• ?(p/P) ? AF(Kd, Ld) - R/P
• MPK - R/P
• change in real profit
• marginal product of capital- real rental price

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Clearing of the Markets for Labor and Capital
Services
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Clearing of the Markets for Labor and Capital
Services

• The Market for Capital Services
• Supply of capital services
• For the economy as a whole, the aggregate
  quantity of capital, K, is given from past flows
  of investment.
• In the short run, the aggregate or market
  quantity of capital services supplied, Ks, equals
  K.

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Clearing of the Markets for Labor and Capital
Services

• The Market for Capital Services
• Clearing of the market for capital services
• R/P will be determined to clear the marketthat
  is, so that the aggregate quantity of capital
  services supplied, K, equals the aggregate
  quantity demanded, Kd
• (R/P) MPK( evaluated at K)

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Clearing of the Markets for Labor and Capital
Services
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Clearing of the Markets for Labor and Capital
Services

• The Market for Capital Services
• The interest rate
• i R/P - d
• rate of return on bonds
• rate of return on ownership of capital
• i MPK ( evaluated at K) - d

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Clearing of the Markets for Labor and Capital
Services

• Profit in Equilibrium
• p/P A F(K,L) - (w/P)L - ( R/P) K
• w/P MPL
• R/P MPK
• p/P A F(K, L) - MPL L - MPK K

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Clearing of the Markets for Labor and Capital
Services

• Zero Profit in Equilibrium

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Clearing of the Markets for Labor and Capital
Services

• Zero Profit in Equilibrium