Dynamic Exchange Economies

Setup
N households
Preferences for household i

t u cit

t=0

Possible generalizations
Different preferences for each household
Non time separable specifications (e.g. habit formation)
Many goods at each point in time (e.g. leisure and consumption)
Other patterns besides exponential discounting (e.g. finite lifetime)
Endowments:

e eit t=0

for i = 1, .., N

Goods are not storable

(storage is a way to convert t-goods into t + 1-goods; when we look at economies with
production well call the available ways of converting one good into another technologies)
An allocation is

c cit t=0

for i = 1, .., N

The allocation for household i is denoted


ci cit t=0

Econ 210, Fall 2013

Pablo Kurlat

Definition 1. An allocation is feasible if it satisfies the resource constraint:

N
X

cit

i=1

N
X

eit

i=1

Markets
Each date is a different good
There is a price pt for consumption goods delivered at date t
All these goods trade in a market at the beginning of time
Normalize p0 1 and denote the price vector by p {pt }
t=0

Competitive Equilibrium
Assume that households behave competitively, taking prices as given
Each household faces the following problem:
max
i
c

t u cit

t=0

s.t.

X
X
i
pt eit
p t ct
t=0

t=0

Definition 2. A competitive equilibrium consists of:

1. A price vector p
2. An allocation c
such that
1. ci solves problem (1) for all i, taking p as given
2. Markets clear:

N
X

cit

i=1

N
X

eit

i=1

Generalizations
Many goods (instead of just one good per date)
Many states of the world
Going beyond exchange economies to economies with production
2

(1)

Econ 210, Fall 2013

Pablo Kurlat

The First Welfare Theorem

Notation: u (ci )

t=0

t u (cit )

Definition 3. A feasible allocation c is Pareto efficient (or Pareto optimal) if there is no other
feasible allocation c such that




u ci u ci




u ci > u ci

i
for some i

Proposition 1. (The First Welfare Theorem). Let c be a competitive equilibrium allocation.

Then c is Pareto efficient
Proof. Assume the contrary. Then, there is a feasible allocation c such that




u ci u ci




u cj > u cj

i
for some j

This implies

X
t=0

pt cit

pt cjt >

X
t=0

pt cit

pt cjt

t=0

t=0

(otherwise allocation c would not be chosen). Adding:

"
N
X
X
i=1

X
t=0

X
t=0

#
pt cit >

t=0
N
X

pt
pt

i=1
N
X

cit >


eit >

"
N
X
X
i=1

X
t=0

X
t=0

i=1

#
pt cit

t=0
N
X

pt

pt

i=1
N
X

cit

eit

i=1

which is a contradiction. (The last step uses that in a competitive equilibrium

P
PN
i
and any feasible allocation c satisfies N
cit ) for all t).
i=1 (et )
i=1 (

PN

i
i=1 ct

PN

i
i=1 et

Econ 210, Fall 2013

Pablo Kurlat

Notice that the theorem requires very few assumptions:

Local nonsatiation
The value of the aggregate endowment is finite, i.e.

t=0 pt

PN

i=1

(eit ) <

but not concavity, exponential discounting, etc.

FWT limits the possible justifications for government intervention
1. Conditions of the theorem not met (imperfect competition, externalities, incomplete
markets, etc.)
2. Redistribution
FWT is useful for finding competitive equilibria (sometimes computing Pareto Optimal allocations is easier than computing equilibria)

Example
N =2
Endowment

(
eti =

1
0

if i + t is even
if i + t is odd

Utility function
u (c) =

4.1

c1
1

Look for the competitive equilibrium directly

Steps:
1. Solve households problem for arbitrary prices
2. Find prices such that markets clear
3. Replace the market-clearing prices in household problem to find equilibrium allocation
1. Household problem

Econ 210, Fall 2013

Pablo Kurlat

FOC for household i:1

t u0 cit i pt = 0


pt
u0 cit = i t

(2)

Note that (2) implies an important property:

i ptt
i
u0 (cit )


=
=
j ptt
j
u0 cjt
so the ratios of marginal utilities across agents are constant over time. This is a quite
general property of competitive models. Whats the logic?
Each household equates its MRS to the relative price
All households face the same relative prices
Therefore all households MRS are equated
Now rearrange (2):


pt
u0 cit = i t

i
i pt
ct
= t

 t  1

cit =
i pt

(3)
(4)

Use budget constraint


pt

t=0

t
i pt

1X
i

 1

1 1

pt

=
t

t=0

t=0

i =

pt eit
pt eit

t=0
1 1 t

t=0 t
P

i
t=0 pt et

"P

Replace in (4)
cit

i
s=0 ps es
P 1 1 s

s=0 ps

t
pt

 1
(5)

2. Market-clearing prices
1

Since the utility function is concave and the budget set is convex, the FOC holds as long as we have an interior
solution. We typically (but not always) make assumptions such that this is indeed the case.

Econ 210, Fall 2013

Pablo Kurlat

Market-clearing condition
c1t + c2t = 1 t
#
 t  1 " P
1
2
p
(e
+
e
)

s
s
s=0 s
=1
P 1 1 s
pt

s=0 s
#
 t  1 " P

s=0 ps
=1
P
1 1 s

pt

s
s=0
Therefore

 t  1

pt

must be constant

Since we have normalized p0 = 1, then

pt = t

(6)

3. Allocation
Replace prices (6) in household decision (5):
cit

4.2

P s i

X
es
s=0
s eis
= P s = (1 )

s=0
s=0
(
1
1 2 if i = 1
=
1
if i = 2
1 2

Look for the equilibrium via the planners problem

Finding a Pareto efficient allocation

max
1 2
c ,c

t u c1t

t=0

s.t.

(7)

c1t + c2t 1

X


t u c2t u
t=0

Solve by setting up a Lagrangian2 :

"
#

X
X






L c1 , c2 , t , =
t u c1t u
t u 1 c1t
t=0
2

t=0

Well talk more about what exactly this means, local & global conditions, necessary and sufficient conditions,

etc.

Econ 210, Fall 2013

Pablo Kurlat

Take FOC:





t u0 c1t u0 1 c1t = 0
u0 (c1t )
=
u0 (1 c1t )
u0 (c1t )
=
u0 (c2t )
so again we have the property that the ratio of marginal utilities is equated across time.
Given that c1 + c2 is constant and equal to 1, we also have that the consumption of each
agent is constant over time, whihc we also found to be true in the competitive equilibrium
Each value of will correspond to a different Pareto efficient allocation
can be interpreted as either a multiplier or as the relative weight of household 2 in the
planners objective function.
By trying all possible values of (0, ), we can trace out all the possible Pareto efficient
allocations.3
Thanks to the FWT, we know one of these is the competitive equilibrium.
Why is this useful?
If we establish properties that all efficient allocations satisfy, we know the competitive
equilibrium satisfies them too
Sometimes (for instance if there is a single household) there is a single efficient allocation;
then we have found the equilibrium
For this particular problem, solving the Planners problem doesnt completely characterize the solution - we would need to find the value of such that the each household
exactly spends their budget

Adding uncertainty
Suppose at each date one of S possible states of the world is realized
Notation:
State at date t: st
3

This is exactly equivalent if the problem is concave.

Econ 210, Fall 2013

Pablo Kurlat

Histories: st = {s0 , s1 , ...st }. We can also write st = {st1 , st }

Endowments: ei (st )
PN

Aggregate endowment: e (st )

i=1

ei (st )

Probabilities: Pr (st )
Conditional probabilities: Pr (st |st1 ) or Pr (st |st1 )
Example:
s {Rain,Sunshine}
Pr (st = Rain|st1 ) = p (iid case)
(
pH
if st1 = Rain
Pr (st = Rain|st1 ) =
(non-iid case)
pL if st1 = Sunshine
More commodities!
Each date/history combination is a different good
Example: consumption goods in period 3 in case of {Rain, Sunshine, Rain}
An allocation is: c = ci (st ) for i = 1, 2, ..., N
An allocation is feasible if

N
X

c s

i=1

u c

X
X

st

t Pr st u ci st

st

t=0

5.1

e i st

i=1

Household i gets utility

i

N
X

The Planners Problem

Look for Pareto Efficient Allocations

max

X
X

t=0

t Pr st u ci st

st

s.t.
N
X

c s

i=1

XX
t

N
X

e i st

st

i=1

Pr st u cj st uj

t=0

st

j 6= i

Econ 210, Fall 2013

Pablo Kurlat

Use Lagrangian / welfare weights:

max
c

X
X

t Pr s

" N
X


t

st

t=0

#
i u ci s

t

i=1

s.t.
N
X

c s

i=1

N
X

e i st

st

i=1

FOC w.r.t. ci (st ):

t Pr st i u0 ci st st = 0
Take ratio of two different households:
u0 (ci (st ))
j
=
u0 (cj (st ))
i

(8)

Ratio of marginal utilities is constant across time and states of the world
Rearrange:
i

c s

0 1

= (u )

1 0 1 t


u c s
i


(9)

(Im taking as a benchmark an arbitrary household 1)

Sum over households:
N
X

c s

i=1

e s

N
X
i=1
N
X

0 1

1 0 1 t


u c s
i

1 0 1 t


u c s
i

(u )

0 1

(u )

i=1

(10)

Equation (10) defines a relationship between c1 (st ) and the aggregate endowment e (st )
In particular c1 (st ) does NOT depend on the individual endowments, only on the sum and
on the weights
By equation (9), this is true of for every household!
A form of full-insurance
This is true of EVERY Pareto efficient allocation
Therefore, by the FWT, it must be true of the competitive equilibrium
9

Econ 210, Fall 2013

5.2

Pablo Kurlat

The Competitive Equilibrium

Complete markets or complete Arrow-Debreu markets: there is a market for each possible
commodity
Trade once for all possible contingent claims
These are sometimes called Arrow-Debreu securities
p (st ): price (in terms of date-0 goods) of one unit of consumption for delivery if history
st is realized
Household problem
max

{ci (st )}t=0

X
X
t=0

t Pr st u ci st

st

s.t.
X
X
X



X




p s t ci s t
p st ei st
t=0

st

t=0

(11)

st

FOC w.r.t. ci (st ):

t Pr st u0 ci st i p st = 0
Take ratios of two different households:
i
u0 (ci (st ))
=
u0 (cj (st ))
j

(12)

so we have the feature that ratios of marginal utilities are equated across time and states of
the world
(This feature has to be true by the FWT since its true for every Pareto efficient allocation,
this just confirms what we knew)
The property that ci (st ) does not depend on ei (st ) (only on e (st )) also holds and can be
tested
If we set the welfare weights in the planning problem to
i =

1
i

where i is what results in equilibrium, then equation (8) coincides with (12) and the planners solution will coincide with the equilibrium
(But we need to know the prices for this, i.e. until we dont solve for prices we dont know
the value of i for household is problem)
10

Econ 210, Fall 2013

Pablo Kurlat

The Representative Agent

Proposition 2. Suppose we have a competitive equilibrium with a price vector p (st ). Let
i

1
i

where i is the Lagrange multiplier on household is budget constraint, and define

uR (x) max

N
X

ci

i u (ci )

i=1

s.t.
N
X

ci x

i=1

Then there exists a competitive equilibrium in an economy with just one agent with preferences
X
X
t=0

and the endowment is e (st ) =

PN

i=1

t Pr st uR c st

st

ei (st ) where the price is p (st )

Proof. By the envelope theorem:

uR (c)
= i u0 (ci )
c
The competitive equilibrium in the many-agents economy satisfies







t Pr st u0 ci st i p st = 0



1 uR (c (st ))
i
t

p
s
=0
t Pr st i

c (st )

uR (c (st ))


t
t Pr st

p
s
=0
c (st )
which is the FOC for a competitive equilibrium in the representative agent economy
The idea of the proof is to show that the SAME prices that arise in competitive equilibrium are the ones that would persuade the representative agent to consume the aggregate
endowment in each history.
This does NOT imply that equilibrium prices dont depend on the distribution of endowments, because the preferences of the representative consumer could depend on this, through
the weights i , which are endogenous to the equilibrium.

11

Econ 210, Fall 2013

Pablo Kurlat

We can establish a stronger result if we assume CRRA preferences

Proposition 3. Suppose we have a competitive equilibrium with a price vector p (st ) and the utility
1
function is u (c) = c1 . Then there exists a competitive equilibrium in an economy with just one
agent with preferences
X
X





t Pr st u c st
t=0

and the endowment is e (st ) =

PN

i=1

st

ei (st ) where the price is p (st )

Proof. The competitive equilibrium in the many-agents economy satisfies

t Pr st u0 ci st i p st = 0






t Pr st ci st
i p s t = 0
 1
t Pr (st )
c s =
p (st )

 1
N

X

1 t Pr (st )
t
i
c s =

p (st )
i=1
 t
 1 N
Pr (st ) X i
1
=

p (st )
i=1
#
" N
X
1

p st
t Pr st c st
=
i
i

1
i

i=1

which is the FOC for consuming c (st ) if the prices are p (st )

Sequential Markets
Suppose that instead of markets for every commodity (i.e. every history) trading at time 0,
we have markets opening up every period, but where you can only trade claims contigent on
the following days realiztion
Notation:
ai (st , st+1 ): number of units of consumption that household i buys in history st contingent on the realization of state st+1 in period t + 1
These claims are sometimes called Arrow securities
q (st , st+1 ): price of a unit of consumption contingent on the realization of state st+1 in
period t + 1, bought in history st

12

Econ 210, Fall 2013

Pablo Kurlat

Households dynamic budget constraint:

X








ci s t +
q st , st+1 ai st , st+1 ei st + ai st
st+1

Note: the numeraire is now the consumption good in each period

Incomplete way to formulate the households problem:
max
i t

X
X

c (s )

t=0

t Pr st u ci st

st

s.t.


t

ci s +

q st , st+1 ai st , st+1 ei st + ai st

st+1

Why is this incomplete? As stated, the problem has no solution, because the household want
to choose ci (st ) = every period
To turn this problem into a problem that makes sense, we need to impose some lower bound
on a (st ), so that the household cannot borrow an infinite amount
Different ways to impose this limit lead to different problems.
Examples:
No borrowing:


ai s t 0
Exogenous debt limit B:


ai st B
Natural debt limit:4
i

a s

X
X
p sk i k

e s

t)
p
(s
k
t
k=t
s |s

where p (st )

Qt

k=1

q sk1 , sk = q (s0 , s1 ) q (s1 , s2 ) q (st1 , st )

No-Ponzi-game condition:
lim

p st+1 a st , st+1 0

sT +1

Note that what we call p (st ) in the sequential formulation is closely related to what we called p (st ) in the
time-0 markets formulation; more on this below.
4

13

Econ 210, Fall 2013

Pablo Kurlat

Well impose that no-Ponzi-game condition, so the problem becomes:

max
i t

X
X

c (s )

t=0

t Pr st u ci st

st

s.t.


t

ci s +

q st , st+1 ai st , st+1 ei st + ai st

(13)

st+1

lim

p st+1 a st , st+1 0

sT +1

Exercise:
1. Show that if either an exogenous of the natural debt limit is imposed, they imply that
the no-Ponzi game condition is satisfied
2. Show that the no-Ponzi-game condition plus nonnegative consumption imply that the
natual debt limit is satisfied
3. Show that constraints (13) are equivalent to (11)
Proposition 4. If {c, p} is a competitive equilibrium with date-0 markets, then letting

p (st+1 )
q st , st+1 =
p (st )
{c, q} is a competitive equilibrium with sequential markets.
Proof. The key step is to show that the budget sets of the household coincide in the two formulations (left as an exercise).
Whats the logic? Suppose I want to buy 1 claim on history st . How much does it cost me?
In history st1 I need to have q (st1 , st ) consumption goods to buy 1 claim on history
st = {st1 , st }
In history st2 I need to have q (st2 , st1 ) q (st1 , st ) consumption goods to buy q (st1 , st )
claims on history st1 = {st2 , st1 }
...
In period 0 I need to have p (st ) = q (s0 , s1 ) q (s1 , s2 ) q (st1 , st ) to buy claims
on history s1 = {s0 , s1 } and keep reinvesting those until I reach history st , and Ill have
achieved my objective

14

Econ 210, Fall 2013

Pablo Kurlat

Asset Pricing
An asset is a stream of dividends d = {d (st )}
Examples:
A consol / perpetuity:


d st = d st
One years worth of car insurance (the period is one month):




d st = r st I (t 12)
where r (st ) is the value of the repairs that my car needs in history st
Any asset can be replicated by Arrow-Debreu securities
Therefore, if we denote the price at time zero of asset d by p0 (d), we must have
p0 (d) =

X
X
t=0

p st d st

(14)

st

Using the FOC for the household (for ANY household!)

t Pr st u0 ci st i p st = 0






1
p st = t Pr st u0 ci st
i
so for the first period:




1
1 = p s0 = u 0 c s0
i



i = u0 c s0
which implies

t Pr (st ) u0 (c (st ))
p st =
u0 (c (s0 ))

This expression is known as the stochastic discount factor

15

(15)

Econ 210, Fall 2013

Pablo Kurlat

The price of an asset is therefore

X t
X
Pr (st ) u0 (c (st ))

p0 (d) =

t
" s
X

u0 (c (s0 ))

t=0

=E

t=0

u0 (c (st ))
t
t 0
d
s
u (c (s0 ))

d st

An asset is worth more if it pays off in high-marginal-utility states of the world

If markets were to reopen in history st , what would be the price of the asset in terms of
history-st consumption goods?
Price of an Arrow-Debreu security that pays in history st+k :
p s

t+k

|s

k Pr st+k |st u0 c st+k
=
u0 (c (st ))

(notice that this implies p st+k |st = 0 if st+k is not a successor of history st )
Price of asset d in history st :





X k
X


Pr st+k |st u0 c st+k
t+k
d
s
pst (d) =
u0 (c (st ))
k=0 k
s

One-period returns of holding asset d from history st up to history st+1 :

d (st+1 ) + pst+1 (d)
R st+t |st =
pst (d)


P P k+1 Pr(st+k+1 |st )u0 (c(st+k+1 ))
d (st+1 ) +
d st+k+1
k=0
sk
u0 (c(st+1 ))
=
P P k Pr(st+k |st )u0 (c(st+k ))
d (st+k )
k=0
sk
u0 (c(st ))
Let

u0 (c (st+1 ))
m st+1
u0 (c (st ))

Then
X

Pr st+1 |st m st+1 R st+t |st =

st+1

X
st+1

P P

d (st+1 ) + k=0
t+1 t
t+1
Pr s |s m s
P P
k=0

16

sk

sk

k+1 Pr(st+k+1 |st )u0 (c(st+k+1 ))

d
u0 (c(st+1 ))

k Pr(st+k |st )u0 (c(st+k ))

d (st+k )
u0 (c(st ))

st+k+1

=1

Econ 210, Fall 2013

Pablo Kurlat

or, summarizing:
E (m R) = 1

(16)

m is sometimes known as a pricing kernel

Notice that equation (16) holds for ANY asset
You will sometimes see equation (16) written as
u0 (ct ) = E [Ru0 (ct+1 )]

(17)

Example: the risk-free rate

Suppose
(
d s

t+k

Then
pst (d) =

1
0

if k = 1
otherwise

X Pr (st+1 |st ) u0 (c (st+1 ))

st+1

u0 (c (st ))

so the risk-free rate is

R=

u0 (c (st ))
1
= P
pst (d)
st+1 Pr (st+1 |st ) u0 (c (st+1 ))

This is just a special case of (17) for the case where R is deterministic so we can take
it out of the expectation operator.

17