Understanding Fluctuations in Markets and Prices

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..