Long Run Growth: The Basic Framework

Abstract

This chapter focuses at the real economy, introducing important concepts for inter-temporal analysis which play a key role in modern monetary policy analysis. We start with a simple two-period endowment economy with one representative agent. We illustrate the concepts of wealth constraint, inter-temporal optimization with time preferences, marginal rate of substitution (MRS), and the real rate interest. We derive optimality conditions for the inter-temporal path of consumption (the Euler equation) and the natural rate of interest as key equilibrium condition. We show that our endowment can be interpreted as a base line model for a growing economy. As next step, we introduce government spending and taxation and extend our base line model by introducing the labor market, making production endogenous. We derive optimal price setting under monopolistic competition in an economy with heterogeneous firms for the case that all firms can adjust their prices optimally without cost. The general equilibrium conditions for this economy provide an important reference point for later analysis, characterizing the natural level of employment, potential output, and the corresponding natural real rate of interest in the absence of nominal rigidities.