dynamic equilibrium - Lecture 2 Dynamic Equilibrium Models...

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Lecture 2 Dynamic Equilibrium Models I : Two Periods 1. Introduction In macroeconomics, we study the behavior of economy-wide aggregates – GDP, saving, investment, employment and so on - and their interrelations. The behavior of aggregates and their interrelations are results of decisions and interactions of consumers and firms in different markets – goods market, labor market, and asset market. In addition, most of the issues in macroeconomics are inherently dynamic. In growth we are concerned with behavior of output, investment, and consumption over long time. Business cycle relates to short-run movements in a number of variables e.g. GDP, employment, real wage, inflation, investment. Saving involves foregoing current consumption for the sake of higher future consumption. Investment decision requires comparison of current cost with expected future returns. Thus in macroeconomics, we are concerned with the behaviors of agents across time and markets i.e. macroeconomics is about dynamics and general equilibrium. In order to analyze macroeconomics issues, we need a framework which can handle both general equilibrium and dynamics. Dynamic general equilibrium (DGE) mod- els provide one such framework. These models ensure that aggregate or economy-wide variables are consistent with the decisions and interactions of individual agents, and the decisions of individual agents are optimal given aggregate variables and other parameters. In this lecture and the next, we will develop basic framework of these models and study some of its applications. DGE models generally have following building blocks: (1) Description of the Economy/ Environment: This section gives details about number and types of goods and agents, preferences (objective functions) of agents, their endowments, technology, structure of markets, trading processes, information structure, timing of events, time period, and sources of shocks. It is extremely impor- tant to clearly describe the economy. Basically this section lays out the structure of the economy and all the assumptions a modeler makes. (2) Optimal Decisions of Agents: This section analyzes optimal behavior of agents subject to given constraints e.g. consumers maximize utility subject to their budget constraint, firms maximize profit. This is partial equilibrium analysis. At this stage, it is very important to differentiate between what variables are choice variables of the agents and what variables they take as given. There are two types of variables - endogenous variables and exogenous variables. Endogenous variables are variables whose solution we are seeking. Exogenous vari- ables are variables given from outside. Endogenous variables are also of two types : (i) individual choice variables, which individual agents choose; and (ii) aggregate or economy-wide endogenous variables, which are not chosen by individual agents, but are the outcomes of their interactions. For example, in the competitive market con- sumption by a consumer or production by a firm is individual choice variable, but the prices are aggregate endogenous variables. Individual agents while making decisions
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