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PART I
SOME ALTERNATIVE NOTIONS OF DEMAND AND SUPPLY IN ASSET MARKETS
Introduction
In Part I of this dissertation I shall discuss three alternative specifications of temporary equilibrium in asset markets and their implications for macroeconomic model building. Chapter 1 contains the theoretical analysis. Chapter 2 applies to the findings of Chapter 1 to a number of familiar small macroeconomic models.
Three notions of temporary market equilibrium are distinguished: beginning-of-period (or instantaneous) portfolio equilibrium, end-of-period equilibrium and transactions equilibrium. To these different notions of market equilibrium correspond different sectoral budget constraints or balance sheet constraints. These aggregate to different economy-wide versions of Walras’ Law, which imply different adding-up requirements for the changes in excess demands resulting from changes in the arguments of the excess demand functions.
These three alternative ways of characterizing temporary market equilibrium are contrasted with the traditional distinction between flow equilibrium and stock equilibrium. The stock equilibrium-flow equilibrium terminology is shown to be potentially misleading.1 The real debate is about what constitutes market demand and supply in the unit period of a sequential temporary equilibrium model.
In the literature, the instantaneous portfolio equilibrium specification has been employed mainly, but not exclusively2 in continuous time models, while the end-of-period portfolio equilibrium specification has been adopted in discrete period models (e.g., see [120], [119]). The transactions equilibrium specification has been used in both continuous and discrete time models to characterize market equilibrium for a subset of the goods in those models (typically the commodity market and labor market), with either kind of portfolio equilibrium characterizing market equilibrium for the remaining goods (typically the financial markets).3
Both continuous and discrete time models are approximations to reality. This has led Foley [53] to the conclusion that the behavior of the model should not depend in an essential manner on the length of the unit period of analysis. By viewing the continuous model as the limiting case of the discrete period model when the length of the period is reduced to zero, he reaches the conclusion that the continuous analogue cf the end-of-period equilibrium model is ill-defined except under perfect foresight. I show that this conclusion is incorrect.
Finally, the relative merits of the three competing notions of asset market equilibrium are discussed. I argue that there are conceptual problems associated with the notion of instantaneous stock demands; this leads me to the conclusion that the end-of-period portfolio equilibrium and the transactions specification correspond more naturally to acceptable notions of market demand and market supply as forces determining the behavior of asset prices and rates of return.
The application of the analysis of Chapter 1 to some simple macro models in Chapter 2 leads to the conclusion that with the beginning of period portfolio equilibrium specification, equilibrium in financial markets can be separated from equilibrium in the commodity (and labor) market in the sense that an excess demand for some financial claim implies an excess supply of equal value of all other financial claims, without any effect on excess supply in the commodity market. The IS/LM dichotomization of financial and real equilibrium (with the bond market equilibrium curve BH coinciding with the LM curve) is the natural representation of this approach. With the transactions equilibrium approach and the end-of-period equilibrium approach one budget constraint (Walras’ Law) applies to all excess demands, real and financial; in the simple IS/LM model the LM curve will no longer coincide with the bond market equilibrium curve. An exception to this occurs in one interpretation of the Keynesian unemployment model when there is disequilibrium in the labor and commodity markets; the LM and BH curves refer to effective demands which are contingent upon realized labor and commodity transactions (see [22]). (A special case of this model specifies the household sector as labor market constrained and the corporate sector as output market constrained (see, e.g. [14])). With this interpretation of the Keynesian model, the LM curve will coincide with the bond market equilibrium curve even if one adopts the transactions equilibrium or end-of-period equilibrium approach.
In the simple models I shall be considering, the major difference between models incorporating different specifications of asset market equilibrium that is of interest to model builders, is the difference in the short-run behavior of the endogenous variables (price level and interest rate in the full employment Patinkin model, output and interest rate in the Keynesian model), when there are changes in asset flows caused e.g., by the changes in the level of government spending. With the beginning-of-period equilibrium specification in financial asset markets, for example, the impact effect of an increase in government spending in the Patinkin model will be to shift the locus of commodity market equilibria (the IS curve) to the right, raising the rate of interest. With the end-of-period equilibrium specification in all markets, the loci of financial market equilibria as well as the IS curve will shift when government spending (and hence the flow supply of financial assets) is increased. This means that the impact effect on the rate of interest could be to lower it rather than to raise it. Analogous results obtain for more complicated models.
1This of course is quite independent of the requirement that two terms that are added together should indeed be dimensionally compatible for addition! This can be important, for example, if market supply is defined as the sum of initial endowment (a stock) and current production (a flow); if the length of the unit period is zero, current production will have the dimension of the instantaneous rate of change of a stock at a point in time, which makes it incompatible for addition with the initial endowment–a stock at a point in time. The best short treatment of dimensionality in economics is still Evans [49], Chapter 2.
2Tobin [167], can be interpreted as an analysis of beginning of period financial market eq...
