Chapter-3 - LECTURE-3 HOUSEHOLD BEHAVIOUR IN COMMODITY AND...

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LECTURE-3: HOUSEHOLD BEHAVIOUR IN COMMODITY AND CREDIT MARKETS - In the real world, people consume a wide variety of goods and services even though they do not contribute to the production of every single one of them. - There exist commodity markets in which households can exchange goods and services. COMMODITY MARKETS - Before the introduction (or more accurately, invention) of money, exchange of goods and services was performed in a barter fashion. Barter means direct exchange of goods and services for other goods and services which requires double coincidence of wants. - Invention of a common measure of “value” in terms of currency solved the problem of double coincidence of wants. That common measure is called money . In a modern economy, money serves as a medium of exchange, store of value and unit of account. - The number of dollars that people receive for each unit of goods sold is the dollar price of the good. THE CREDIT MARKET - In the previous model we assumed a single period in which goods cannot be stored and households are not allowed to save. - For now, we will retain the assumption that goods cannot be stored but relax the assumption about household saving. - In the real world, lending and borrowing activities between two (or more) parties are carried out by the means of a piece of paper called bond. Borrowers issue bonds and exchange them for the amount of money they borrow. The bond defines the terms of this transaction between the borrower and the lender such that if a person issues 1 unit of bond in exchange of $1 of money, she borrows $1. - For simplicity we assume that all bonds have a maturity of one period at the end of which the borrower is required to pay the principal , $1, plus interest $R. BUDGET CONSTRAINT - Given these assumptions, the budget constraint of the household for a single period can be constructed as follows: t t t t t t m b Pc m R b Py + + = + + + - - 1 1 ) 1 ( where: - the variable P denotes the price level.
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- 1 - t b represents the number of bonds in dollar units that a household holds during period t. This value can either be negative or positive depending on whether the household is a net lender or borrower. If 1 - t b <0 then the household is a borrower and is a lender if otherwise. - 1 - t m denotes the amount of money held over from the previous period. - t c denotes the consumption expenditures at time t. - The budget constraint simply tells us that the dollar amount of the current consumption expenditures plus savings cannot exceed that of the current income plus interest income (or interest payments depending on whether the household is a net borrower or lender). Reorganizing the above terms, one can obtain the below expression: I I I I I I I I I savings t t t t t t t m m b b Pc R b Py 1 1 1 - - - - + - + = + BUDGET CONSTRAINT FOR TWO PERIODS - Now suppose that we can think of the life of a typical household in terms of two periods: Young age and old age. For the young age period the budget constraint is: 1 1 1 0 0 1 ) 1 ( m b Pc m R b Py + + = + + + - For simplicity let’s assume that money holdings of a typical household stay constant over time. In other words, households only save in the form of bonds,
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