In a closed-economy setup, like in Gali’s book, how do households transfer resources between periods? Gali states that “no assets are traded in equilibrium” due to the assumption of a representative household in Chapter 2.
I sometimes consider this to mean that the sell-side will completely offset the buy-side of the bonds market (in aggregate) so that, in equilibrium or steady-state, aggregate bonds are zero (B=0). May I ask if that is a proper way to think about it? Because C=Y all the time even when there is a shock and we deviate from equilibrium. If there is a contractionary monetary policy shock, for example, C (=Y) falls. But, how does B change? Implicitly, does aggregate bonds (B) increase (although we cannot explicitly find how much amount of B is traded following the shock)?
No, in the basic model there is no resource transfer between periods as there is no net savings device. Plans of agents have to adjust so that there is zero net demand/supply for the bond.
Many thanks, Prof. Pfeifer for the reply. In this case, how does monetary policy work? If there is a contractionary monetary policy shock, aggregate C(=Y) falls. Is this fall in C(=Y) still due to a higher real interest rate following the shock? Like, if the CB raises interest rates, households reduce their consumption, wanting to send resources to the future. But because Y falls to match the fall in C, we have a lower C(=Y) but zero aggregate savings? Thus, C(=Y) can fall with no change to savings, right? Is that the intuition?
And also, if I may ask, why do we need a transversality condition for aggregate bonds in this case? Because aggregate savings (on net), is zero in every year anyway. Thanks.
Yes, that is the intuition. Labor needs to adjust in response to the change in the interest rate to get the desired consumption path.
The TVC is a constraint to the optimization problem. It defines optimal behavior of the household and is independent of the subsequent market clearing condition. If you were to impose market clearing directly, there would be no choice of the household.
Many thanks, Prof. Pfeifer. May I ask one last question if I may? Does the channel of monetary policy transmission first pass through the firm sector or the household sector? Thus…
- Households first adjust their consumption due to the change in the real interest rate, and then firms react to that adjustment by change labour and output.
- Firms first adjust their labor and output due to the change in the real interest rate, and then households react to that adjustment by changing their consumption accordingly.
- It does not matter, probably because they occur simultaneously.
It’s number 3. The central bank only sets the nominal interest rate. Conceptually, that first affects households, whose demand would change. That will affect firms and their prices, which all jointly determines the real interest rate and all other equilibrium variables.