Professor Mark Gertler Macroeconomic Theory I Fall 2002 Lecture 1

Two-Period Competitive Equilibrium Model

The core of the real business cycle model as well as of much of modern aggregate dynamic economic analysis is the competitive intertemporal general equilibrium model. Here we present a simple two period version to illustrate some basic ideas.

Environment
One representative household that: consumes, supplies labor, saves and receives divi-

Two periods: 1 and 2.

dend income (from ownership of rms.) One representative rm that produces output, demands labor, invests in new capital, and pays dividends to households. The household and the rm act competitively, i.e., each takes market prices as given. The household owns the rm. Preferences The household consumes in both periods, but only works in period 1. Let Ci be household consumption in period i and N household labor supply in period 1. Then household preferences are given by u(C1 ) + u(C2 ) (N ) with : u(0) = 0, u0 () > 0, u00 () < 0, u0 (0) = , u0 () = 0, (0) = 0, 0 () > 0, 00 () > 0, 0 (0) = 0, 0 () = , and (1)

0 < < 1.1 These properties imply that u() is increasing and concave and that () is increasing and convex. Concavity of u() implies diminishing marginal utility of consumption, while convexity of () suggests increasing marginal disutility from labor supply. The parameter is known as the households subjective discount factor. It reects how the household weights consuming in the future relative to consuming today. Technology The rm produces output in period 1 using labor input, and produces output in period 2 using capital, which depends upon the amount of period 1 investment, I. Let Yi be output in period i. Then each period, production is given by

Y1 = 1 f (N ) Y2 = 2 g (I ) The production functions have the following properties: f (0) = 0, f 0 () > 0, f 00 () < 0, f 0 (0) = , f 0 () = 0, g (0) = 0, g 0 () > 0, g 00 () < 0, g 0 (0) = , g0 () = 0. where 1 and 2 are technology parameters.

(2) (3)

The concavity of f () and g () reects diminishing marginal product of the respective input: holding constant all other factors of production, increasing one input raises output, but the incremental gains shrink as the level of input usage rises. In our simple example, think of production depending on both labor and capital, but that in period 1, capital is xed and in period 2 labor is xed (and equal to zero). For example, we can re-write the production functions as: 1 ). Y1 = 1 F (N, K
The conditions u0 (0) = , u0 () = 0, 0 (0) = 0, 0 () = are known as Inada conditions and guarantee an interior solution in equilibrium with positive and nite values of Ci and N.
1

Y2 = 2 G(0, K2 ) with 1. K2 = I + (1 )K where is the rate of depreciation. Capital in period 2 depends on period 1 investment plus 1 and xing period 2 labor capital leftover from period 1. Given that we are taking as given K at zero, we can write 1 ) 1 f (N ) Y1 = 1 F (N, K 1 ) 2 g (I ) Y2 = 2 G(0, I + (1 )K Economy-Wide Resource Constraints In period 1, output is divided between consumption and investment: there is no government and no external sector.

Y1 = C1 + I In period 2, all output is consumed.

(4)

Y2 = C2

(5)

Household and Firm Behavior

Let S be household saving, i dividends in period i, W the real wage, and R the gross

The Households Decision Problem

real interest rate (equal to one plus the net interest rate), all in units of consumption goods.

Further, we normalize the price of consumption goods at unity. The representative household
d d chooses C1 , C2 , S, N s to solve

d d max u(C1 ) + u(C2 ) (N S )

(6)

subject to:
d C1 = W N S + 1 S d C2 = RS + 2

(7) (8)

where the superscripts d and s reect demand and supply decisions, respectively. The household takes as given W, R, 1 and 2 . Note that S may be positive or negative. Negative values of S imply borrowing. Implicit in our formulation, however, is the assumption of perfect capital markets; i.e., the household is able to borrow at the same rate R for which it is able to lend. It is instructive to combine the two period budget constraints given by (7) and (8) into a single intertemporal budget constraint given by
d C1 + d C2 2 = W N S + 1 + . R R

(9)

According to equation (9), the households lifetime consumption plan must satisfy the constraint that the present value of consumption is equal to the present value of income. The latter is given by the sum of labor income in the rst period and the discounted stream of dividend income. Accordingly, consumption depends on lifetime income as opposed to income in the current period. This implication, however, depends on the assumption of perfect capital markets. What permitted collapsing the period budget constraints into the single intertemporal constraint for negative as well as positive values of S is that the value of R is independent of the sign of S ; i.e., the individual can freely borrow or lend at the gross rate R. To solve the households decision problem, it is simplest to turn the constrained problem into an unconstrained one by plugging (7) and (8) into (1). This is possible as long as the 4

two one-period budget constraints are always binding, so that there is no unused income. This latter condition is ensured by the assumptions we made on u().

The representative household accordingly chooses S and N s to solve max u(wN S + 1 S ) + u(RS + 2 ) (N S ),

given W, R, 1 , 2 . The rst order necessary condition with respect to N S is given by:
d W u0 (C1 ) | {z }

MB of Labor Supply

MC of Labor Supply

The household adjusts labor supply until marginal benet in utility terms, the real wage times the marginal utility of consumption, equals the marginal disutility of labor eort. Our restrictions on preferences guarantee that equation (10) describes a local optimum (i.e., that the second order condition holds.) To express marginal benet and cost in units of
d consumption goods, divide by u0 (C1 ) to obtain:

0 (N S ) | {z }

=0

(10)

W =

0 (N S ) . d u0 (C1 )

(11)

The marginal benet in units of consumption goods is simply the real wage. The marginal cost in units of consumption goods is 0 (N S ) normalized by the marginal utility benet of
d working, u0 (C1 ).

We can use the rst order condition given by equation (11) to construct a labor supply schedule for the household. Combining the budget constraint (7) with (11) yields 0 (N S ) u0 (W N S + 1 S )

W =

(12)

The labor supply curve is dened as combinations of W and N S that satisfy equation (12), given 1 and S . Note that there are two channels via which a shift in W may aect N S . The rst is a substitution eect: a rise in W raises the marginal benet of working (the left side). The second is an income eect that raises the marginal cost by reducing the 5

marginal utility of an additional unit of consumption (the denominator on the right side.) Since the marginal cost of working is increasing in N s , the substitution eect induces a rise in labor eort, while the income eect induces a decline. We will assume preferences such that the substitution eect dominates, implying that the supply curve slopes upward in (W, N ) space. This boils down to restricting the concavity of the utility function. As we show later, standard parametrizations of utility functions satisfy this criteria. The rst order necessary condition with respect to saving is given by:
d u0 (C d ) + Ru0 (C2 ) =0 | {z 1 } | {z } MB of Savings

(13)

MC of Savings

The opportunity cost of saving a unit of goods is the marginal utility of consumption. The marginal benet is the gross real rate times the marginal utility of future consumption (from the standpoint of today.) Again, restrictions on the utility function ensure that the rst order condition characterizes an optimum. Rearranging equation (13) yields a relation between marginal utilities of consumption across time, known as a consumption euler equation:
d d u0 (C1 ) = Ru0 (C2 )

(14)

Given concavity of the utility function, the consumption euler equation implies that individuals should try to smooth consumption over time. In the limiting case where R = 1, it is optimal for individuals to consume the same amount each period. Note that the consumption euler equation combined with the intertemporal budget constraint determines the optimal lifetime consumption plan, i.e., the optimal values of C1 and C2 . Note that this simple model captures the key aspects of the life-cycle permanent income hypothesis developed by Friedman and Modigliani. The key aspects are consumption smoothing and the dependence of consumption on lifetime resources. To obtain an expression in terms of consumption goods, rearrange the consumption euler equation as follows: 6

1/R =

d ) u0 (C2 . d 0 u (C1 )

(15)

The left side is the price in units of current consumption of a unit of future consumption (i.e., to buy a unit of second period consumption, the individual must save 1/R units of current consumption). The right side is the households intertemporal marginal rate of substitution - the value the household places on a an additional unit of future consumption in units of current consumption. Finally, to obtain a saving supply curve, invert equation (15) and combine with the period budget constraints to obtain: u0 (W N S + 1 S ) u0 (RS + 2 )

R=

(16)

We dene the saving supply curve as combinations of R and S that satisfy equation (16), given W and N s . In analogy to the labor supply curve, there is both a substitution and an income eect of changes in R . A rise in R increases the opportunity cost of saving (the substitution eect). However, it also reduces the marginal value of second period consumption by reducing the marginal utility of second period consumption (the income eect). Given that the intertemporal marginal rate of substitution (the inverse of the right side of equation (16)) is decreasing in S, the substitution eect of a rise in R, increases savings, while the income eect decreases them. We will assume the substitution eect dominates, as holds with standard preference specications. The implication is that the saving supply curve will be upward sloping in (R, S ) space. To nd a complete solution to the households decisions problem, combine the two rst order necessary conditions (10) and (13) with the two period budget constraints (7) and (8)
d d to solve for the four choice variables (S, N s , C1 , C2 ). In general, the number of FOCs plus

the number of constraints has to equal the number of variables we need to solve for. The Firm The rm maximizes the discounted stream of prots returned to the household. Given 7

that there is no uncertainty, the rm discounts future prots at the rate 1/R. Accordingly, the rm chooses N d , I, 1 , and 2 to solve 2 R

max 1 + subject to:

(17)

1 = 1 f (N d ) W N d 2 = 2 g (I ) RI. spending.

(18) (19)

taking as given W and R. The rm borrows at the rate R in period 1 to nance investment

Again, we can convert the problem into an unconstrained maximization problem by plugging the constraints (18) and (19) into (17). The rm then chooses N d and I to solve max 1 f (N d ) W N d + 2 g (I ) I R

The rst order necessary conditions for labor and new capital investment are given by: 1 f 0 (N d ) = W 2 g0 (I ) = R (20) (21)

According to equation (20), the rm adjusts labor demand until the marginal benet, given by the marginal physical product of labor, equals the marginal cost, given by the real wage. Equation (21) similarly suggests that the rm invests to the point where the marginal benet, given by the marginal physical product of capital, equals the marginal cost, given by the gross real interest rate. In each case, diminishing marginal product ensures that the rst order condition reects an optimum. From the rms decision problem we obtain demand curves for labor and investment. The labor demand curve is given by combinations of W and N d that satisfy equation (20). The investment demand curve is given by combinations of R and I that satisfy equation (21). 8

Competitive Market Equilibrium A competitive equilibrium for this economy is an allocation (N, I, C1 , C2 , Y1 , Y2 ) and a relative price vector (W, R) such that the household and the rm is each maximizing its respective objective, markets clear, and the economy resource constraints are satised. In practice, to determine the six quantity variables: N, I, C1 , C2 , Y1 and Y2 , we need six independent relations. We have two market-clearing conditions, two resource constraints and two technological constraints (the two production functions). The market clearing conditions embed optimal household and rm behavior. (As a rule of thumb, the number of market clearing conditions must equal the number of relative prices in the model.) A competitive equilibrium allocation, accordingly, is the vector (N, I, C1 , C2 , Y1 , Y2 ) that satises the following six conditions: Labor Market: 1 f 0 (N ) = Capital market: 2 g 0 (I ) = Resource Constraints: Y1 = C1 + I, C2 = Y2 Technology Constraints: Y1 = 1 f (N ) Y2 = 2 g (I ) (26) (27) (24) (25) u0 (C1 ) u0 (C2 ) (23) 0 (N ) . u0 (C1 ) (22)

Figure 1 shows the equilibrium in the dierent markets.

R

R=

d u ' ( c2 )

d u ' (c1 )

R*

R = 2 g '(I )
I*

I W
Y2 = 2 g ( I )

Y2

Y2 = C 2

Y2

W =

v'(N s )
d u ' ( c1 )

Y2*

Y2* W*

W = 1 f '( N d )
C2*

C2 C1
Y1*

I*

I Y1
Y1 *

N*

Y1 = 1 f ( N )

C1*

Y1 = C 1 + I
I*

N*

Figure 1: Equilibrium in the assets and labor markets. The equilibrium price vector is obtained from the respective market clearing conditions, i.e., W = 1 f 0 (N ) = 0 (N ) u0 (C1 )

(28)

R = 2 g0 (I ) =

u0 (C1 ) u0 (C2 )

(29)

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Note that the competitive equilibrium can be fully described as a function of the primitives of the model; including preference and technological parameters, as well as the resource constraints of the economy. Note also that the outcome is ecient in the sense that it is not possible to reallocate inputs to increase welfare. Consider the problem of a social planner who is choosing allocations to maximize households welfare subject to the technology and resource constraints. The planners problem is as follows:

max u(C1 ) + u(C2 ) (N S ) subject to (24), (25), (26), and (27). The rst order necessary conditions are given by 1 f 0 (N ) = 0 (N ) u0 (C1 )

2 g 0 (I ) =

u0 (C1 ) u0 (C2 )

along with the four resource and technology constraints. Thus, the equations that characterize the solution to the planning problem are identical to those that describe the competitive equilibrium. Key to the result is the absence of market externalities (e.g. returns to scale, imperfect information) that could interfere with households and rms ability to internalize all the social marginal benets and costs from their decisions. Note also that while the model determines relative prices, it does not determine nominal prices (e.g. prices in dollars.) For that matter, money has no explicit role. Finally, to have the model explain output and employment uctuations, something exogenous must vary. The natural candidates in this framework are the technology and the preference parameters.

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