Markets, Prices, Supply, and Demand

Chapter 6 Markets, Prices, Supply, and Demand Macroeconomics Chapter 6

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) Macroeconomics Chapter 6

Markets in the Macroeconomy Goods market Households Households (Firms) Labor market Bond market Rental market Macroeconomics Chapter 6

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. Macroeconomics Chapter 6

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. Macroeconomics Chapter 6

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 PYis the dollar value per year of the goods bought and sold on the goods market. Macroeconomics Chapter 6

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. Macroeconomics Chapter 6

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. Macroeconomics Chapter 6

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. Macroeconomics Chapter 6

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 Kdpays the nominal amount RKdper year and then gets to use the capital as an input to production. • The real rental price is R/P. Macroeconomics Chapter 6

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. Macroeconomics Chapter 6

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. Macroeconomics Chapter 6

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. Macroeconomics Chapter 6

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. Macroeconomics Chapter 6

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. Macroeconomics Chapter 6

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. Macroeconomics Chapter 6

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. Macroeconomics Chapter 6

Constructing the Budget Constraint • Income • Profits • Households may earn profit—an excess of revenue over costs—from their business activities. • Y= A·F( Kd, Ld) • π = PY − (wLd+ RKd) • π = P A·F( Kd, Ld) − ( wLd+ RKd) Macroeconomics Chapter 6

Constructing the Budget Constraint • Income • Wage income • If households supply the quantity of labor Lsto the labor market, they receive the nominal wage income of wLsper year. • Quantity of labor supplied is the fixed amount L, so nominal wage income is wL. Macroeconomics Chapter 6

Constructing the Budget Constraint • Income • Rental income • If households supply the quantity of capital Ksto the rental market they receive the nominal rental income of RKsper year. • Since households supply all of their available capital, K, to the rental market, so that Ks= K, the nominal rental income is RK. Macroeconomics Chapter 6

Constructing the Budget Constraint • Rental income • The quantity δK of capital disappears each year. The dollar value of this lost capital is P·δK. • net nominal rental income= nominal rental income− value of depreciation • net nominal rental income = RK−δPK • net nominal rental income = (R/P)·PK−δPK • net nominal rental income= (R/P−δ)·PK • Rate of return on owning capital= R/P−δ Macroeconomics Chapter 6

Constructing the Budget Constraint • Interest Income • If a household’s 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. Macroeconomics Chapter 6

Constructing the Budget Constraint • Total income • Household nominal income= nominal profit + nominal wage income + nominal net rental income+ nominal interest income • Household nominal income =π+wL+(R/P−δ)·PK+iB Macroeconomics Chapter 6

Constructing the Budget Constraint • Consumption • Households consume goods in the quantity C per year at price P • Household nominal consumption= P C Macroeconomics Chapter 6

Constructing the Budget Constraint • Assets • Households hold assets in three forms: • money, M; • bonds, B; • ownership of capital, K. Macroeconomics Chapter 6

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 household’s nominal money holdings is zero • ∆M=0 Macroeconomics Chapter 6

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 −δ. • Rate of return on bonds= rate of return on ownership • i = R/P − δ Macroeconomics Chapter 6

Constructing the Budget Constraint • Household nominal income = π + wL + i ·( B+ PK ) Macroeconomics Chapter 6

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 Macroeconomics Chapter 6

Constructing the Budget Constraint • Household Budget Constraint • nominal saving= nominal income− nominal consumption • nominal saving= π+ wL + i ·( B+ P K ) − P C • ∆B + P ·∆K = π+ wL + i·( B+ PK)−PC Macroeconomics Chapter 6

Constructing the Budget Constraint • Household Budget Constraint in Nominal Terms • PC + ∆B + P·∆K = π+ wL + i·( B+ PK ) • nominal consumption + nominal saving = nominal income Macroeconomics Chapter 6

Constructing the Budget Constraint • Household Budget Constraint real terms • C + (1/P)·∆B+ ∆K = π/P + (w/P)·L + i·(B/P+K) • consumption + real saving = real income Macroeconomics Chapter 6

Constructing the Budget Constraint Macroeconomics Chapter 6

Clearing of the Markets for Labor and Capital Services • Profit Maximization • Real Profit • π/P = A·F(Kd,Ld) − (w/P) ·Ld− (R/P) ·Kd • real profit= output − real wage payments − real rental payments Macroeconomics Chapter 6

Clearing of the Markets for Labor and Capital Services Macroeconomics Chapter 6

Clearing of the Markets for Labor and Capital Services • The Labor Market • Demand for labor • ∆(π/P) = ∆[ A·F( Kd, Ld) ] − w/P • = MPL − w/P • change in real profit= marginal product of labor− real wage rate Macroeconomics Chapter 6

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. Macroeconomics Chapter 6

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) Macroeconomics Chapter 6

Clearing of the Markets for Labor and Capital Services • The Market for Capital Services • Demand for capital services • ∆(π/P) = ∆[ A·F(Kd, Ld) ] − R/P = MPK − R/P • change in real profit= marginal product of capital− real rental price Macroeconomics Chapter 6

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. Macroeconomics Chapter 6

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 market—that is, so that the aggregate quantity of capital services supplied, K, equals the aggregate quantity demanded, Kd • (R/P)* = MPK( evaluated at K) Macroeconomics Chapter 6

Clearing of the Markets for Labor and Capital Services • The Market for Capital Services • The interest rate • i = R/P − δ • rate of return on bonds= rate of return on ownership of capital • i = MPK ( evaluated at K) − δ Macroeconomics Chapter 6

Clearing of the Markets for Labor and Capital Services • Profit in Equilibrium • π/P = A·F(K,L) − (w/P)·L − ( R/P)·K • w/P = MPL • R/P = MPK • π/P = A·F(K, L) − MPL·L − MPK·K Macroeconomics Chapter 6

Clearing of the Markets for Labor and Capital Services • Zero Profit in Equilibrium Macroeconomics Chapter 6

Markets, Prices, Supply, and Demand