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Equilibrium in A Pure Exchange Economy

This document outlines an equilibrium model in a pure exchange economy. It begins with the primitives of the model, including agents, endowments, and preferences. It then discusses the Arrow-Debreu equilibrium, including the characterization of the state-price density process, existence and uniqueness of equilibrium, and the representative agent. It also briefly discusses security market equilibrium and the consumption capital asset pricing model (CAPM). The document concludes with three problems related to defining the representative agent's utility function, proving market clearing in security markets, and determining interest rates in the Arrow-Debreu equilibrium for an economy with identical agents.

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53 views3 pages

Equilibrium in A Pure Exchange Economy

This document outlines an equilibrium model in a pure exchange economy. It begins with the primitives of the model, including agents, endowments, and preferences. It then discusses the Arrow-Debreu equilibrium, including the characterization of the state-price density process, existence and uniqueness of equilibrium, and the representative agent. It also briefly discusses security market equilibrium and the consumption capital asset pricing model (CAPM). The document concludes with three problems related to defining the representative agent's utility function, proving market clearing in security markets, and determining interest rates in the Arrow-Debreu equilibrium for an economy with identical agents.

Uploaded by

closyurais
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Equilibrium in a Pure Exchange Economy

Detailed outline

1. Primitives{agents, endowments, preferences

2. Arrow-Debreu equilibrium

(a) Characterization of state-price density process


(b) Existence and uniqueness of equilibrium
(c) Representative agent

3. Security market equilibrium

4. Consumption CAPM

Readings

Du±e, chapter 10.

Karatzas and Shreve, 1998, chapter 4.

Merton, R., 1973, An intertemporal capital asset pricing model, Econometrica 41, 867-
888.

Breeden, D., 1979, An intertemporal asset pricing model with stochastic consumption
and investment opportunities, Journal of Financial Economics 7, 265-296.

Karatzas, I., J.P. Lehoczky, and S. Shreve, 1990, Existence and uniqueness of multi-agent
equilibrium in a stochastic, dynamic consumption/investment model, Mathematics
of Operations Research 15, 80-128.
Problems

1. De¯ne the representative agent utility function u by


m
X m
X
u(c; t) ´ max ¸j uj (cj ; t) s.t. cj · c ; (1)
(c1 ;:::;cm )
j=1 j=1

where for all j = 1; : : : ; m, uj (¢; t) is C 3 , u0j (c; t) > 0, u0j (c; t) ! 1 as c ! 0,


u0j (c; t) ! 0 as c ! 1, and u00j (c; t) < 0. Let (c¤1 (c); : : : ; c¤m (c)) be the optimal
solution. Prove that u(¢; t) : (0; 1) ! R has the following properties:

(a) u(¢; t) is C 2 ,
(b) u0 (c; t) = ¸j u0j (c¤j (c); t) 8 j = 1; : : : ; m,
(c) u0 (c; t) ! 1 as c ! 0,
(d) u0 (c; t) ! 0 as c ! 1,
(e) u00 (c; t) < 0.

2. Consider an economy with m agents with preferences as described above and endow-
ment processes ejt ; j = 1; : : : ; m on [0; T ]. Suppose the state-price density process
Ht and consumption plans cj¤ t ; j = 1; : : : ; m, on [0; T ] form an Arrow-Debreu equi-
librium. Let S0 ; S1 ; :::; Sd be the prices of a riskless asset and d risky assets with
nonsingular (d £ d)-dimensional volatility matrix process ¾t . Suppose these assets
are in zero net supply. Suppose that instead of trading Arrow-Debreu consump-
tion plans explicitly, agents continuously trade the d + 1 assets to implement their
optimal consumption. Let the m (d + 1)-dimensional processes ¼tj be the trading
strategies that ¯nance the agents' optimal consumption plans. Prove that the d + 1
security markets clear, that is, prove
m
X
¼tj = 0 2 Rd+1 ; 8 t 2 [0; T ] :
j=1
3. Consider an economy with identical agents each deriving expected utility from con-
sumption plan fct g equal to
Z T c°t
E e¡½t dt ; ° 2 (0; 1) : (2)
0 °
The aggregate endowment process, et , satis¯es
det
= ¹e (t) dt + ¾e (t) dBt (3)
et
where Bt is d-dimensional Brownian motion and ¹e and ¾e are bounded, progres-
sively measurable processes taking values in R and Rd , respectively.

(a) Determine the interest rate process rt in the Arrow-Debreu equilibrium for this
economy.
(b) Suppose r^t is an arbitrary bounded, nonnegative, progressively measurable
process. Construct an equilibrium in which the interest rate is r^t .
(c) Suppose r^t above is an It^o process with d^
rt = ¹r (t) dt + ¾r (t) dBt . What is the
drift of r^t under the martingale measure P ¤ in the equilibrium you constructed?

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