RomerChapter6ontheLucasModel-HenryChappell.docVIP

Romer Chapter 6 on the Lucas Model The Case of Perfect Information Producer Behavior There are many different goods. A representative producer of a typical good, good i, produces according to the production function: (6.1) where is the amount the individual works and is the amount he produces. Real consumption, is nominal income divided by a price index: . Utility depends positively on consumption and negatively on hours worked: (6.2) Substituting the previous equations into (6.2) gives: . (6.3) Taking prices as given, an individual maximizes utility by selecting to satisfy the first order condition: . (6.4) Rearranging, we get: (6.5) Letting lowercase letters denote logs: (6.6) This is a labor supply function (and, indirectly, an output supply function) in which an individual’s hours depend on the relative price of the individual’s output price. Note that this supply function does not include inertial effects like those in the Lucas paper we read earlier. Note that if , then (the utility function was designed so that this would be the result). Demand We assume that the demand for good i has the following form (note: this is NOT derived from a utility maximization problem): , (6.7) where y is the log of a measure of aggregate income, is a shock to demand for good i (with mean zero across goods), and is the demand elasticity. More specifically, y is defined to be the average of the across goods, and p is defined to be the average of the across goods: (6.8) and . (6.9) Aggregate demand is given by: (6.10) This is just a simple way of modeling aggregate demand; the essential property is that the price level and output are inversely related. While m can be literally interpreted as the log money supply, it might be thought of more generally as any aggregate demand shifter. Equilibrium We require that quantities dema