Lecture - 18 Wk 11

EC4004 Lecture 18 Markets & The Macroeconomy Dr Stephen Kinsella

Households

Today

Recap Constructing the BC

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Households

Labour: L (w) Capital: K (r)

Products Profit= PY-(wL+rK)

Products Profit= PY-(wL+rK)

Bonds iB

Products Profit= PY-(wL+rK)

Bonds iB

Labour w/P*Ls

Products Profit= PY-(wL+rK)

Bonds iB

Capital r/P - δ

Labour w/P*Ls

Constructing the Budget Constraint

Constructing the Budget Constraint Quantities and prices determined on four markets will determine household income.

Constructing the Budget Constraint Quantities and prices determined on four markets will determine household income.

Constructing the Budget Constraint Quantities and prices determined on four markets will determine household income. Total sources of funds must equal the total uses of funds.

Constructing the Budget Constraint Quantities and prices determined on four markets will determine household income. Total sources of funds must equal the total uses of funds.

Constructing the Budget Constraint Quantities and prices determined on four markets will determine household income. Total sources of funds must equal the total uses of funds. This equality is the household budget constraint.

Income

Constructing the Budget Constraint

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Constructing the Budget Constraint Income

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Constructing the Budget Constraint Income Profits

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Constructing the Budget Constraint Income Profits Households earn profit—an excess of revenue over costs— from their business activities.

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Constructing the Budget Constraint Income Profits Households earn profit—an excess of revenue over costs— from their business activities. • Y= A· F( Kd, Ld )

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

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Constructing the Budget Constraint Income Profits Households 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)

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Constructing the Budget Constraint

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Constructing the Budget Constraint Income

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Constructing the Budget Constraint Income Wage income

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Constructing the Budget Constraint Income Wage income If households supply the quantity of labour Ls to the labour market, they receive the nominal wage income of wLs per year.

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

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Constructing the Budget Constraint

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Constructing the Budget Constraint Income

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Constructing the Budget Constraint Income Rental income

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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.

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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

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Constructing the Budget Constraint Income

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Constructing the Budget Constraint Income Rental income

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Constructing the Budget Constraint Income Rental income The quantity δK of capital disappears each year.

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Constructing the Budget Constraint Income Rental income The quantity δK of capital disappears each year. The euro value of this lost capital is P· δK.

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Constructing the Budget Constraint Income Rental income The quantity δK of capital disappears each year. The euro value of this lost capital is P· δK. • net nominal rental income= nominal rental income− value of depreciation

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Constructing the Budget Constraint Income Rental income The quantity δK of capital disappears each year. The euro value of this lost capital is P· δK. • net nominal rental income= nominal rental income− value of depreciation • net nominal rental income = RK − δ P K

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Constructing the Budget Constraint Income Rental income The quantity δK of capital disappears each year. The euro value of this lost capital is P· δK. • net nominal rental income= nominal rental income− value of depreciation • net nominal rental income = RK − δ P K • net nominal rental income = (R/ P)·P K − δ P K

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Constructing the Budget Constraint Income Rental income The quantity δK of capital disappears each year. The euro value of this lost capital is P· δK. • net nominal rental income= nominal rental income− value of depreciation • net nominal rental income = RK − δ P K • net nominal rental income = (R/ P)·P K − δ P K • net nominal rental income= ( R/ P − δ) · P K

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Constructing the Budget Constraint

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Constructing the Budget Constraint Income

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Constructing the Budget Constraint Income Rental income

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Constructing the Budget Constraint Income Rental income • rate of return on owning capital= R/ P − δ

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Constructing the Budget Constraint

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Constructing the Budget Constraint Income

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Constructing the Budget Constraint Income Interest Income

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Constructing the Budget Constraint Income Interest Income If a household’s nominal bond holdings are B, the flow of nominal interest income received is iB per year.

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Constructing the Budget Constraint Income 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.

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Constructing the Budget Constraint

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Constructing the Budget Constraint • Total income

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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

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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 = π + wL + (R/P − δ) · PK + iB

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Constructing the Budget Constraint

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Constructing the Budget Constraint Consumption

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Constructing the Budget Constraint Consumption Households consume goods in the quantity C per year at price= P

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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

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Constructing the Budget Constraint Assets

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Constructing the Budget Constraint Assets Households hold assets in three forms:

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Constructing the Budget Constraint Assets Households hold assets in three forms: money, M;

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Constructing the Budget Constraint Assets Households hold assets in three forms: money, M; bonds, B;

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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

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Constructing the Budget Constraint Assets

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Constructing the Budget Constraint Assets Assume households hold a fixed amount of money in euro terms.

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Constructing the Budget Constraint Assets Assume households hold a fixed amount of money in euro terms. We assume that the change over time of a household’s nominal money holdings is zero

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Constructing the Budget Constraint Assets Assume households hold a fixed amount of money in euro terms. We assume that the change over time of a household’s nominal money holdings is zero ∆M=0

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Constructing the Budget Constraint

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Constructing the Budget Constraint Assets

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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 − δ.

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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 − δ. Rate of return on bonds= rate of return on ownership

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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 − δ. Rate of return on bonds= rate of return on ownership i = R/ P − δ

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Constructing the Budget Constraint

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Constructing the Budget Constraint • Household nominal income=

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Constructing the Budget Constraint • Household nominal income= π + wL + i · ( B+ P K )

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Constructing the Budget Constraint

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Constructing the Budget Constraint Household Budget Constraint

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Constructing the Budget Constraint Household Budget Constraint –nominal value of assets= M+ B+ P K

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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.

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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)

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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

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Constructing the Budget Constraint Household Budget Constraint

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Constructing the Budget Constraint Household Budget Constraint –nominal saving= nominal income− nominal consumption

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Constructing the Budget Constraint Household Budget Constraint –nominal saving= nominal income− nominal consumption – nominal saving= π + wL + i · ( B+ P K ) − P C

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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 ) − P C

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Constructing the Budget Constraint

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Constructing the Budget Constraint Household Budget Constraint in Nominal Terms

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Constructing the Budget Constraint Household Budget Constraint in Nominal Terms – PC + ∆B + P·∆K = π + wL + i·( B+ P K )

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

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Constructing the Budget Constraint

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Constructing the Budget Constraint Household Budget Constraint real terms

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Constructing the Budget Constraint Household Budget Constraint real terms – C + ( 1/ P)·∆B+ ∆K = π/ P + ( w/P)·L + i·(B/P+K)

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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

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Constructing the Budget Constraint

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Clearing of the Markets for Labour and Capital Services

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Clearing of the Markets for Labour and Capital Services Profit Maximization

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Clearing of the Markets for Labour and Capital Services Profit Maximization Real Profit

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Clearing of the Markets for Labour and Capital Services Profit Maximization Real Profit π/P = A·F(Kd,Ld) − (w/P) · Ld − (R/P) · Kd

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Clearing of the Markets for Labour and Capital Services Profit Maximization Real Profit π/P = A·F(Kd,Ld) − (w/P) · Ld − (R/P) · Kd • real profit= output

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Clearing of the Markets for Labour 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

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Clearing of the Markets for Labour and Capital Services

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Clearing of the Markets for Labour and Capital Services

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Clearing of the Markets for Labour and Capital Services The Labour Market

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Clearing of the Markets for Labour and Capital Services The Labour Market Demand for labour

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Clearing of the Markets for Labour and Capital Services The Labour Market Demand for labour ∆(π/P) = ∆[ A·F( Kd, Ld) ] − w/ P

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Clearing of the Markets for Labour and Capital Services The Labour Market Demand for labour ∆(π/P) = ∆[ A·F( Kd, Ld) ] − w/ P = MPL − w/P

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

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Clearing of the Markets for Labour and Capital Services

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Clearing of the Markets for Labour and Capital Services

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Clearing of the Markets for Labour and Capital Services Supply of labour

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Clearing of the Markets for Labour and Capital Services Supply of labour We are assuming that each household supplies a fixed quantity of labour to the labour market.

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Clearing of the Markets for Labour and Capital Services Supply of labour We are assuming that each household supplies a fixed quantity of labour to the labour market. Therefore, the aggregate or market supply of labour, Ls, is the given amount L.

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Clearing of the Markets for Labour and Capital Services

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Clearing of the Markets for Labour and Capital Services Clearing of the labour market

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Clearing of the Markets for Labour and Capital Services Clearing of the labour market –w/P is determined to equate the aggregate quantity of labour demanded, Ld, to the aggregate quantity supplied, L.

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Clearing of the Markets for Labour and Capital Services Clearing of the labour market –w/P is determined to equate the aggregate quantity of labour demanded, Ld, to the aggregate quantity supplied, L.

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Clearing of the Markets for Labour and Capital Services Clearing of the labour market –w/P is determined to equate the aggregate quantity of labour demanded, Ld, to the aggregate quantity supplied, L. ( w/ P)* = MPL ( evaluated at L)

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Clearing of the Markets for Labour and Capital Services

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Clearing of the Markets for Labour and Capital Services

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Clearing of the Markets for Labour and Capital Services The Market for Capital Services

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Clearing of the Markets for Labour and Capital Services The Market for Capital Services Demand for capital services

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Clearing of the Markets for Labour and Capital Services The Market for Capital Services Demand for capital services ∆(π/P) = ∆[ A·F(Kd, Ld) ] − R/P

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Clearing of the Markets for Labour and Capital Services The Market for Capital Services Demand for capital services ∆(π/P) = ∆[ A·F(Kd, Ld) ] − R/P = MPK − R/P

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Clearing of the Markets for Labour and Capital Services The Market for Capital Services Demand for capital services ∆(π/P) = ∆[ A·F(Kd, Ld) ] − R/P = MPK − R/P

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Clearing of the Markets for Labour 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=

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Clearing of the Markets for Labour 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

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Clearing of the Markets for Labour and Capital Services

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Clearing of the Markets for Labour and Capital Services

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Clearing of the Markets for Labour and Capital Services The Market for Capital Services

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Clearing of the Markets for Labour and Capital Services The Market for Capital Services Supply of capital services

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Clearing of the Markets for Labour 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.

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Clearing of the Markets for Labour 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 Labour and Capital Services

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Clearing of the Markets for Labour and Capital Services The Market for Capital Services

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Clearing of the Markets for Labour and Capital Services The Market for Capital Services Clearing of the market for capital services

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Clearing of the Markets for Labour 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

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Clearing of the Markets for Labour 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)

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Clearing of the Markets for Labour and Capital Services

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Clearing of the Markets for Labour and Capital Services

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Clearing of the Markets for Labour and Capital Services The Market for Capital Services

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Clearing of the Markets for Labour and Capital Services The Market for Capital Services The interest rate

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Clearing of the Markets for Labour and Capital Services The Market for Capital Services The interest rate • i = R/P − δ

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Clearing of the Markets for Labour and Capital Services The Market for Capital Services The interest rate • i = R/P − δ • rate of return on bonds=

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Clearing of the Markets for Labour 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

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Clearing of the Markets for Labour 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

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Clearing of the Markets for Labour 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

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Clearing of the Markets for Labour and Capital Services

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Clearing of the Markets for Labour and Capital Services Profit in Equilibrium

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Clearing of the Markets for Labour and Capital Services Profit in Equilibrium π/P = A· F(K,L) − (w/P)·L − ( R/P)· K

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

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

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Clearing of the Markets for Labour 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

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Next Time: Business Cycles

Read Barro, Cht 8

EC4004 Lecture 18 Markets & The Macroeconomy Dr Stephen Kinsella