Macroeconomic Market Equilibrium

General Equilibrium §

Market Equilibrium is a point that is both optimal and feasible:

1. Optimality: HHs, firms, govn’t are maximally happy; $\pi$, $u$ maximized, government plan is in place
2. Feasibility: Budget/Resource Constraints are in action

Feasibility §

1. Labor Market: $N^S=N^D$
2. Goods Market: $Y^S=C+G$ ←“Resource Constraint”
3. HH income: $C+T=wN+\pi$ ←”Consumer Budget Constraint”
4. Government $G=T$ ←”Government Budget Constraint”

⇒ If the two of three budget constraints are satisfied, the other one is automatically satisfied

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Deriving the Equilibrium §

1. Production Possibility Frontier §

• PPF indicates current level of technology, levels of govn’t spending
• Gradient of the PPF is the Marginal Rate of Transformation ($MRT$) of the economy; i.e. opportunity cost of transforming between consumption and leisure. This is equivalent to wage.
• Government speding is indicated by a downward shift of the PPF

2. Household Optimization §

• Consider: even if households do not work, they will get $\pi +\text{Net Transfers}$ amount of income

1+2: Market Equilibrium §

At Point $A^{\ast }(C^{\ast },L^{\ast })$:

• Firms produce maximally, HHs maximize utility
• Is feasible [=inside PPF, inside HH budget constraint]
• $MRS=MRT=-w$

Examples of Disequilibrium

→ The left case: $MRS=MRT$ but is infeasible $\because$ household indifference curve is outside → The right case: feasible, but household utility is not maximized

Changes in Equilibrium §

1. Changes in Government Spending [= $G$], normally due to war, or infrastructure projects

Government can crowd out private consumption, because it reduces HH income (income effect):

Taxes↑ ⇒ HH income ↓ ⇒ $Y^D$↓ ⇒ $N^S$↓ ⇒ $Y$ likely increases $\because$ $\stackrel{\uparrow }{Y}=\stackrel{\downarrow }{C}+\stackrel{\Uparrow }{G}$