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Economics 2152A/B
Jennifer Mori

THE REAL INTERTEMPORAL MODEL chapter 11The next step in building the model will be to construct a goods and services market We will call this simply the goods market for shortThis is the market we are all familiar with as consumersWe begin by using the labour market of our model and the fact that there are two periods to obtain the supply of goodsFirstly we need to model how our labour market supply is affected now that agents make decisions based on lifetime income in other words over the two periods in the modelNotice we will have three prices to content withrthe real interest rate w the real wage rate w the future real wage rateThe new price is the future real wage rate This must be taken into account since our representative agent makes choices based on both current and future incomeIn the future period the utility function isU clTherefore the consumer will reach a maximum level of utility when MRS wl c The remaining two conditions must still holdw MRS lcAnd MRS cc1rThus our consumer will make choices such that these three conditions are metSince either present or future consumption is considered in all three choices this means the labour market will be affectedRemember as soon as a consumption choice is taken a corresponding leisure choice is made Likewise as soon as a leisure choice is madea work choice is made We can summarize this in three points But first let us stipulate that we are assuming substitution effects dominate income effects1 If the current real wage increases we know that the opportunity cost of leisure increases therefore we move up ALONG the upward sloping labour supply curve Thus more labour is supplied to the production function of our economy We would expect more output to be produced Recall the production function is YKN2 If the real interestrate increases this means that the price of current leisure increases Why Because any income saved in the current period will now pay more in terms of real consumption in the futureIt is very important to remember that the PRICE of CURRENT leisure is w1rOr in words if I take leisure now it will cost me what I could have been paid if I had worked plus what that income could have earned in interest This total amount of real income would have been available for consumption in the future period The price of leisure in the future in a TWO period model is just what you could have been paid had you worked Therefore this amount would just be the future wage rate wThus the price ratio of leisure between the current and future periods is w1rwIf real interest rate increases then the price of current leisure increasesyou take less leisure and work more Again more labour would be supplied to the economy and output would rise This will occur at the going wage rate Therefore at the current wage rate the supply of labour curve will SHIFT 3 Suppose that the consumer received more non labour income For example suppose that firms paid out higher dividends This would increase the consumers wealthAn increase in non labour income has JUST INCOME EFFECTS No price has changed Since both leisure and consumption are normal goods an increase in wealth will cause the consumer to take more leisure at ANY GIVENWAGE RATE therefore the labour supply curve will SHIFTIn sum change in current wagemovement along Ns change in real interestshift right for anincreaseshift left for a decrease change in wealthshift left for an increaseshift right for a decrease
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