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CAPITAL AND THE STABILITY OF TTONNEMENT

PRICING REVISITED

Sergio Parrinello*

University of Rome La Sapienza

(March 2004; revised August 2004)

ABSTRACT

This paper reconsiders a recent criticism which contends that the theory of general intertemporal equi-

librium, formulated by taking the physical endowments of capital goods as given, is not protected from

the problem of capital at the centre of the two Cambridges debate of the 1960s. The author confirms

such a criticism following a different approach. He argues that the stability analysis of an intertem-

poral equilibrium via ttonnement must be consistent with a uniform rate of return on capital. He

shows that the resulting non-orthodox ttonnement subverts the traditional analysis of equilibrium

stability.

1. INTRODUCTION

method adopted to deal with time and uncertainty and to preserve the basic

theory of general equilibrium within the WalrasDebreuArrowHahn

tradition. Commodities are specified by the time and the state of nature at

which they are available. In particular dated commodities characterize the

theory of intertemporal equilibrium. It seems that the qualitative properties

* Thanks to two referees and to Enrico Bellino, Pierangelo Garegnani, Michael Mandler and

Bertram Schefold for useful discussion, criticism and comments at different stages of elabora-

tion of this paper, under the usual exemption from responsibility. This article is a revised and

extended version of the authors Working Paper no. 67 published by the Dipartimento di Econo-

mia Pubblica, Universit di Roma La Sapienza, April 2004, and has benefited from the finan-

cial support of the University itself. A preliminary outline of section 4 was presented by the

author at the Conference Sraffa o unaltra Economia, organized by the Dipartimento di

Innovazione e Societ of the University of Rome La Sapienza, Rome, 1213 December 2003.

Blackwell Publishing Ltd 2005, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main

Street, Malden, MA 02148, USA.

Ttonnement Pricing Revisited 515

quasi-dynamic equilibrium. In fact, the theorems of existence, uniqueness

and stability which have been proved for a timeless equilibrium should

directly apply to the intertemporal version of the theory if the number and

the specification of the commodities would be the only change at issue.

This paper reconsiders a recent criticism addressed by Garegnani (2003)

to the theory of intertemporal equilibrium, which leads us to deny the

equivalence illustrated above. We shall point out that an intertemporal

equilibrium requires a specific stability analysis which departs from the

traditional approach derived from Samuelsons seminal contribution.

Such a specificity may lead to different stability properties, although the

same proofs of existence and uniqueness of equilibrium apply to both

versions.

Garegnani argues that aggregate (in terms of value) saving and investment

functions belong to the determinants of an intertemporal equilibrium, and

that the properties of such functions can be a specific source of non-

meaningful equilibria, which is not subsumed under the traditional income

or wealth effects. The quasi-equilibrium method adopted by Garegnani

(2003) in his criticism is questionable and we share the objections which

Schefold (2004) has addressed to it. However, we should not throw the baby

out with the bathwater. We contend that Garegnanis criticism is valid in-

dependently of his quasi-equilibrium method. We shall reformulate the

argument using a different approach which runs through the following ana-

lytical steps: (i) the recognition of the existence of a uniform rate of return

associated with an intertemporal equilibrium; (ii) a reinterpretation of the

model of individual behaviour underlying the excess demand functions;

(iii) the adoption of a non-orthodox ttonnement pricing consistent with

Jevons law; and (iv) the focus on the properties of the demand for capital

flows as a specific source of possible non-meaningful equilibria. In particu-

lar, we shall explain why the auctioneer must follow a ttonnement, in

which the rule for the adjustment of the relative prices of commodities avail-

able at different times is different from the rule applied to the relative prices

of contemporary commodities. Most importantly, we shall point out why a

certain value aggregation intrudes into the determination of prices outside

equilibrium, despite the fact that the model assumes heterogeneous physical

capital goods. This result, which was anticipated by Garegnani (2003),

seems to be a challenge for the stability analysis of intertemporal general

equilibrium, because it points out that the scope of the criticism to the

neoclassical theory of value and distribution, focused on non-monotonic

factor demand functions, is not confined to the aggregate version of that

theory.

516 Sergio Parrinello

INTERTEMPORAL EQUILIBRIUM

which Hahn (1982) used in his criticism of the neo-Ricardians and which

Garegnani (2003) resumed to introduce his criticism of the theory of

intertemporal equilibrium. Our revision consists in assuming that (i) each

market is cleared in equilibrium by strictly positive prices and strict equality

between demand and supply and (ii) the techniques are given and linear. The

economy is assumed to exist for one period starting at time t = 0 and ending

at time t = 1. The commodities of the economy are two non-storable goods

a, b available at times t = 0, 1 and labour performed during the period [0, 1].

Let Pa0, Pb0 be the prices of a, b available at t = 0; Pa1, Pb1, the prices of a, b

available at t = 1; W1 the wage rate. Such prices are nominal and wages are

assumed to be paid at t = 1.

The price equations under perfect competition and constant returns to

scale:

(1)

Pb1 = l bW1 + a b Pa 0 + bb Pb0

where la, lb are given positive labour coefficients, aa, ba, ab, bb are given posi-

tive coefficients of goods a, b used as circulating capital. The technology is

assumed to be viable. Let Djt(), j = a, b, denote the demand function for con-

sumption of goods a, b available at time t = 0, 1 and () the relation with the

independent variables (Pa0, Pb0, Pa1, Pb1, W1).

Market clearing equations for commodities available at t = 0:

A0 = Da 0 () + (aa A1 + a b B1 ) (2)

B0 = Db0 () + (ba A1 + bb B1 )

where A0, B0 are given total endowments of goods a, b at t = 0 and which are

supposed to be allocated according to given individual property rights; A1,

B1 are quantities of goods a, b produced during the period and available for

consumption at t = 1.

Labour market clearing:

l a A1 + l b B1 = L (3)

Market clearing equations for commodities available at time t = 1:

Ttonnement Pricing Revisited 517

A1 = Da1 ()

(4)

B1 = Db1 ()

time t = 1.

All demand functions are positively homogeneous of degree zero in

(Pa0, Pb0, W1, Pa1, Pb1) and satisfy the Walras identity:

A0 Pa 0 + B0 Pb0 + LW0 Da 0 ()Pa 0 + Db0 ()Pb0 + Da1 ()Pa1 + Db1 ()Pb1 (5)

Let us take good b available at t = 1 as the standard of value and have the

equation of price normalization as

Pb1 = 1. (6)

therefore a solution to (1)-(2)-(3)-(4)-(6) under the non-negativity constraints

determines the quantities produced A1, B1 and the prices Pa0, Pb0, Pa1, Pb1, W.

An equilibrium solution determines also the quantities consumed at t = 0, 1,

the quantities saved and invested at t = 0, and implies null quantities saved

and invested at t = 1. The functions of aggregate saving S0() and aggregate

investment I0() are defined by

(7)

I 0 () [aa Da1 () + a b Db1 ()]Pa 0 + [ba Da1 () + bb Db1 ()]Pb0

S0(), I0() can serve for the interpretation of an equilibrium, but they seem

to play no distinct causal role for the determination of the equilibrium itself,

in comparison with the demand and supply functions of the individual phys-

ical commodities.1

Let us replace the quantities A1, B1 in (2), (3) by the equations (4) and the

prices Pa1, Pb1 in the demand functions, Djt(), j = a, b; t = 0, 1, by the price

equations (1). Let P = (Pa0, Pb0, W1) denote the price vector and djt(P) the

1

This negative remark has been already put forward by Schefold (2004).

518 Sergio Parrinello

excess demand functions are

E b0 (P) d b0 (P) + ba d a1 (P) + bb d b1 (P) - B0

E L (P) l a d a1 (P) + l b d b1 (P) - L

the following identity, derived from the Walrass law (5) and from the assump-

tion that the markets for consumption goods at time t = 1 are in equilibrium

(equation (4)):

The typical difficulty of ttonnement for a production economy, under con-

stant returns to scale, is solved here by transforming model (1), (6) into a

reduced form to which ttonnement pricing is applied. This amounts to the

method of calling prices suggested by Schefold (2003).2 In our case, such

ttonnement analysis becomes a quasi-equilibrium analysis also because

the markets for consumption goods at t = 1 are assumed to be always in

equilibrium.

Let Ha(Ea0(P)), Hb(Eb0(P)), HL(EL(P)) be sign-preserving functions of the

excess demands, with Ha(0) = Hb(0) = HL(0) = 0. Let t denote the logical time

attached to the iterations performed by the Walrasian auctioneer and let the

following differential equations describe an orthodox ttonnement:

dPa 0

= H a (E a 0 (P))

dt

dPb0

= H b (E b0 (P)) (9)

dt

dW1

= H L (E L (P))

dt

2

At each iteration the auctioneer is supposed to call only the prices of the initial endowments

and to receive back from the producers the information on the prices of goods a, b at t = 1,

which satisfy (1) and, in a more general model with alternative methods of production, are asso-

ciated with the choice of the cost minimizing techniques; next the auctioneer receives the infor-

mation on the individual net demands and calculates the corresponding aggregate excess

demands in order to call new prices of the initial endowments.

Ttonnement Pricing Revisited 519

where the prices satisfy the equations Pb1 = lbW1 + abPa0 + bbPb0 = 1 and the

functions Ha(), Hb(), HL() satisfy the identity abHa() + bbHb() + lbHL() 0.

Then, given the initial call of prices, P(0), a path of subsequent calls P(t),

t > 0, can be determined by any two differential equations chosen from (9)

and by the numeraire equation.

Therefore, the determination not only of an equilibrium solution, but also

of the stability properties of such a ttonnement rule leaves no causal role

to the functions S0(), I0(), of aggregate saving and investment. We may

concede that, granted the validity of the Walrass law (5), we could replace

one equation chosen from (1)(4) with the equation S0() = I0() to calculate

an equilibrium solution. This substitution does not leads us far, because it

does not assign to S0(), I0() any special role in the adjustment mechanism.

However the auctioneer, instead of calling prices according to equations (9),

is compelled to follow a different rule, if the theory has to be consistent with

the extension of Jevonss law to the prices of capital goods.

Assume that in equilibrium Pa0 > 0, Pb0 > 0, Pa1 > 0, Pb1 > 0, W1 > 0 and define

P P P P

the own rates of interest ra a 0 - 1, rb b0 - 1. Let pa 0 = a 0 , pa1 = a1 ,

Pa1 Pb1 Pb0 Pb1

Pb0 P W

pb0 = = 1, pb1 = b1 = 1, w1 = 1 denote current relative prices with good

Pb0 Pb1 Pb1

b chosen as the numeraire at each time. The price equations at current prices

are

(10)

pb1 = l bw1 + (a b pa 0 + bb pb0 )(1 + rb )

pa1 - l a w1 pa 0 - l a w0

= 1 + rb

pa 0 - l a w0 aa pa 0 + ba pb0

(10)

pb1 - l bw1 pb0 - l bw0

= 1 + rb

pb0 - l bw0 a b pa 0 + bb pb0

3

It should be noticed that the same rate rb, the own rate of interest in the numeraire, applies to

both equations (10). In particular, the first equation, which pertains to the industry of good a,

can be written

520 Sergio Parrinello

w1

where w0 is the discounted wage rate. Equation (10) sets that the

1 + rb

factor of return, received from investing in the production of a certain good,

is uniform and equal to 1 + rb, the own factor of interest on the numeraire.

The effectiveness of each return results from the multiplication of two terms

in brackets: (1) the factor of appreciation of a bundle of a good and of a

bad (i.e. a labour coefficient); (2) the own factor of profit calculated at

contemporary prices. It should be stressed the fact that the assumption of

constant returns to scale, adopted in this paper, is useful to maintain

as a benchmark the model used by Hahn and Garegnani for different pur-

poses, but it merges a general equalization between rates of returns

and a particular equalization which is implied by the price equations derived

from that assumption. If the assumption of constant returns to scale

should be replaced with the assumption of decreasing returns, the corre-

sponding price equations would not imply that the average rate of return on

capital invested in each industry is equal to the own rate of interest on the

numeraire. However, the following relation must be satisfied in force of

Jevonss law (the law of unique price) independently of the type of returns

to scale:

pa1 p

(1 + ra ) = b1 (1 + rb ) (11)

pa 0 pb0

Equation (11) sets a relation between the effective factors of return received

from saving and lending the goods a, b. The effective rate of return on each

good is calculated by multiplying its own factor of interest for the factor of

appreciation of the good itself. It should be noted that (11) pertains to the

sphere of exchange (not to the sphere of production) and must be interpreted

as an equation, although its mathematical form resembles a tautology.4 The

usual notation of the relative prices, written as ratios between nominal prices,

can be indeed misleading. In fact (11) can be written

Pa1 W P P P

pa1 = = la w1 + (aa pa 0 + ba pb0 )(1 + rb ) = la 1 + aa a 0 + ba b0 bo

Pb1 Pb1 Pb0 Pb0 Pb1

which shows that the equation at current prices is consistent with the equation at discounted

prices, Pa1 = laW1 + aaPa0 + baPb0, i.e. with the first equation (10). This consistency would be

missing if rb should be replaced with ra in the first equation (10).

4

Schefold (2004, p. 11) seems to interpret an equation like (11) as a tautology.

Ttonnement Pricing Revisited 521

=

Pb1 Pa 0 Pa1 Pb1

tion of (11). The relative price associated with a direct exchange of two com-

modities is not equal by definition to the corresponding relative price which

is implicit in a chain of (e.g. triangular) exchanges involving other com-

modities.5 Hence (11) is not an identity, but an equilibrium condition. It must

be interpreted as an application of Jevonss law (the law of unique price),

which is assumed to hold both in equilibrium and in disequilibrium with

ttonnement pricing. Equation (11) is the outcome of spot-forward arbitrages

on goods a, b, and it might be violated if the markets were not perfect. Since

good b is the numeraire, equation (11) becomes

pa1

(1 + ra ) = 1 + rb . (11)

pa 0

It follows from (10), (11) that rb represents the uniform effective rate of

return, which in the model applies to saving, lending and productive invest-

ment. The recognition of a uniform rate of return for an economy, which is

not in a long-period equilibrium, is a crucial step of the argument.

Garegnani asserts (1) that capital goods are perfect substitutes for the saver

and (2) that the properties of the relative prices of commodities available

at different times (intertemporal relative prices) are different from those

pertaining to the relative prices of commodities available at the same time

(contemporary or current relative prices). In the theory of intertemporal

equilibrium (1) and (2) must be grounded on an explicit model of individual

choice. We shall specify such a model through some intermediate steps, which

aim to avoid certain possible misunderstandings.

Hahns (Garegnanis) model, let us assume that the demand functions of

5

For example, Pa1/Pb1 = 4/1 and Pb0/Pa0 = 1/2 mean that 1 unit of a1 is exchanged for 4 units of

b1 and 2 units of b0 are exchanged for 1 unit of a0. However, it would be logically possible that

(i) 2 units of a0 are not exchanged for 1 unit of a1 and (ii) 1 unit of b0 is not exchanged for 1

unit of b1. Instead market equilibrium via arbitrage rules out (i), (ii) and therefore the equations

Pa0/Pa1 = 1/2, Pb0/Pb1 = 1/1 must hold.

522 Sergio Parrinello

model (1)(6) are derived from the rational choices of the individual con-

sumer, who is supposed to solve the problem:

max u()

s.t. the intertemporal budget constraint (12)

a0 Pa 0 + b0 Pb0 + lW1 = ca 0 Pa 0 + cb0 Pb0 + ca1Pa1 + cb1Pb1

where l is the labour endowment; a0, b0 are the initial endowments of goods

a, b and cjt is the dated consumption of good j, j = a, b, t = 0, 1; and u() is

the utility function, all notations being referred to the consumer.

In microeconomics the attribute perfect substitutes has a definite meaning

in the following cases:

(i) if we specify u() = u(ca0, cb0, ca1, cb1) and we assume that the marginal

rate of substitution between two consumption goods is constant (perfect

substitutes);

(ii) if we define the indirect utility function6 as the maximum direct utility

achievable at given prices and income: f(Pa0, Pb0, Pa1, Pb1, W1, y)

max u(ca0, cb0, ca1, cb1) s.t. y = ca0Pa0 + cb0Pb0 + ca1Pa1 + cb1Pb1, where y =

a0Pa0 + b0Pb0 + lW1, and we say that the physical constituents of y are

perfect substitutes;7

(iii) if we assume that the consumer postpones at t = 1 the choice of goods

to be consumed at t = 1 and we specify u() = u(ca0, cb0, s), where s =

(a0 - ca0)Pa0 + (b0 - cb0)Pb0 is his total saving at discounted prices. In

this case we can say that the physical constituents of s are perfect

substitutes.

not fit into any of cases (i), (ii), (iii) above. In particular, the model (1)(6)

rules out case (iii), because the choice of the whole intertemporal plan of

consumption and saving is supposed to be made only at time t = 0 and there-

fore the rational consumer does not attach any utility to the degrees of

freedom (flexibility, liquidity) of choice at time t = 1. Still cases (ii) and (iii)

suggest that another reason exists for the saver to treat the capital goods as

6

See Varian (1992, section 7.2).

7

For example, the marginal rate of substitution of b0 with a0 is equal to fa0/fb0, where fa0, fb0 are

the partial derivatives of f() with respect a0, b0. As f() is a function of the function y(), we have

fa0/fb0 = pa0/pb0.

Ttonnement Pricing Revisited 523

perfect substitutes, even though they do not enter into the (direct or indirect)

utility function of the consumer. In fact, we may distinguish different facets,

roles, functions of the same decision maker: he is a consumer, a saver, an

investor and a worker at the same time. Each facet can be supposed to max-

imize some objective function and the (non-schizophrenic) result is an

optimal plan of consumption c*a0, c*b0, c*a1, c*b1, as a solution to problem (12).

Besides the signals of the net demands for goods and of the supply of labour

services which are sent by the consumer

the saver sends the signal of his optimal saving plan at t = 0 (with no saving

at t = 1):

( ) (

s* = a0 - ca*0 Pa 0 + b0 - cb*0 Pb0 )

It remains to explain why s* can be an independent effective signal. Why are

six signals, instead of five, received by the auctioneer as distinct effective

market signals?

We can imagine that the saver receives from the consumer (the same indi-

vidual) the quantities not consumed (a0 - ca0), (b0 - cb0) and the purpose of

the former is to transform their value s = (a0 - ca0)Pa0 + (b0 - cb0)Pb0 into the

maximum purchasing power available at t = 1. As in case (ii), the physical

constituents of s are perfect substitutes for him, at the given prices Pa0, Pb0.

He would change the physical composition (a0 - ca0), (b0 - cb0) of s before

lending the goods, if all contemporary arbitrages were not fully exploited;

otherwise he is indifferent to the basket of goods contained in s. For the same

reason the physical constituents of the income that he received from the bor-

rowers at the end of the period are perfect substitutes for the saver. He would

exploit all possible spot-forward arbitrages if equation (11) were not initially

satisfied, otherwise he is indifferent to the physical composition of the income

that he receives from the borrowers at t = 1. We should also note that for the

saver perfect substitutability implies indifference in the choice of the physi-

cal mix of saving only if the prices given to him satisfy Jevonss law expressed

by equation (11), which concerns the effective own rates of return. Of

course, saying that the goods a, b are perfect substitutes for the saver does

not mean that they are such also for the consumer. Each dated good a, b is

physically homogeneous; yet, from the point of view of the two facets of the

individual, ca0, cb0, ca1, cb1 are consumption goods, whereas (a0 - ca0), (b0 - cb0)

are capital goods.

524 Sergio Parrinello

The argument presented in the previous section points out that the auction-

eer can call only certain relative prices and must follow different rules for

calling the relative prices of contemporary commodities (contemporary

prices) and the relative prices of commodities available at different times

(intertemporal prices).

In the model the degrees of freedom for calling prices are limited by two

distinct limitations.

A first limitation is inherent in the assumption that we borrowed from

Schefold in order to apply a ttonnement pricing to a production economy

which is subjected to constant returns. At first sight the assumption seems to

prescribe that the auctioneer can call only the nominal prices of the three

inputs, Pa0, Pb0, W1 and then the cost-minimizing choices under perfect com-

petition will determine the prices of the commodities available at t = 1, Pa1,

Pb1, as from the price equations (1). However, labour is not a stock available

at t = 0 but a flow variable, and wages are supposed to be paid at t = 1, when

the products will be available. Therefore, it is just as possible for the auc-

tioneer to call the nominal prices of two inputs Pa0, Pb0 and the nominal price

of one output, say Pb1, and leave the price equations to determine the wage

rate W1 and the price Pa1. This is what we assumed in sections 2 and 3. In

each case the auctioneer can call only three nominal prices: the prices of two

contemporary commodities and the price of one commodity available at a

different time.

The second kind of limitation for calling prices is central to our argument

and is independent from the assumption of constant returns to scale reflected

by the price equations (1), (10). It rests on the fact that Jevons law prevents

the auctioneer from controlling each own rate of return independently from

the others. At each iteration he cannot call prices which violate equations

(11) or (11). A change in rb drags up or down all equalized own effective

rates of return. The ttonnement pricing must obey this second constraint.

We shall formalize such a ttonnement in the next section, but let us first

generalize the second characterization for a multicommodity and many

period economy.

Let us assume an economy in which n produced commodities are available

at dates 0, 1, . . . , T and labour is performed in periods [0, 1], [1, 2], . . .

[T - 1, T]. For the sake of the argument let us disregard the first constraint

Ttonnement Pricing Revisited 525

returns to scale. We claim that the auctioneer is not allowed to fix a dated

good as the unique numeraire. He cannot fix, e.g. good n available at t = T as

the numeraire and call n(T + 1) - 1 arbitrary relative prices Pjt/PnT and T arbi-

trary relative wages Wt/PnT (assuming that good n is not a free good). Instead

he may choose good n as a numeraire8 at each date t and then, beside the

unit own price of good n at t, call (n - 1)(T + 1) + T current (contemporary)

relative prices:

P11 Pn1 , P21 Pn1 , . . . , Pn-1,1 Pn1 ,W1 Pn1

KKKKKKKKKKKKKKKK

P1T PnT , P2 T PnT , . . . , Pn-1,T PnT ,WT PnT

chosen as the numeraire (good n) over periods [0, 1], [1, 2], . . ., [T - 1, T]:

It should be noticed that the total number of relative prices which the auc-

tioneer can call is not at issue. In the absence of the constraint related to con-

stant returns, the traditional auctioneer can call n(T + 1) + T - 1 relative

prices on the whole. The second limitation allows him to call the same total

number of prices, n(T + 1) + T - 1, but it prescribes a different selection of

relative prices on the basis of the distinction between contemporary and

intertemporal relative prices.

Which rules does the auctioneer follow to adjust the prices under his control?

The auctioneer must follow different rules for changing prices, according to

the distinction between current (contemporary) relative prices and the

intertemporal relative price of the numeraire. A change in a current relative

price is governed by the traditional rule which prescribes that the sign of the

change in the price is equal to the sign of the excess demand of that good.

8

Alternatively, he might take a basket made with one unit of each good available at time t

as the standard of value for each date t and period t, t + 1 and fix: P1t + P2t + . . . + Pnt = 1,

t = 0, 1, . . . , T.

526 Sergio Parrinello

numeraire (the own rate of interest which represents the uniform effective

rate of return) cannot be directly affected by the physical excess demand for

the good itself. Only the sign of the total value of the excess demands for all

investment goods at time t can induce the auctioneer to change the uniform

effective rate of return of period t in a definite direction.9 This brings about

a quite different ttonnement, compared with the orthodox one described by

equations (9).

7. HETERODOX TTONNEMENT

the effective rate of return. The individual budget constraint at current prices

with pb0 = 1, pb1 = 1 is

lw1 c p c

aa pa 0 + b0 + = ca 0 pa 0 + cb0 + a1 a1 + b1 (13)

1 + rb 1 + rb 1 + rb

The aggregate demand function for commodity j at time t is: Djt(pa0, pa1, w1,

rb). We can replace the prices pa1, w1 in Djt() with a solution to the price equa-

tions (10), provided that rb falls within its feasible range. We obtain the

demand function djt(pa0, rb). Let us define the price vector p = (pa0, rb) and

the excess demand functions:

E b0 (p) db0 (p) + ba da1 (p) + bb db1 (p) - B0

E L (p) l a da1 (p) + l b db1 (p) - L

current prices:

9

The causal role assigned to the aggregate capital flows (i) does not presuppose a monetary

economy under uncertainty and (ii) does not pose an additional threat to methodological indi-

vidualism, in addition to that which is already implicit in the rudimentary price dynamics based

on the assumption of the auctioneer who calls unique prices. On (i) and (ii) we do not share the

criticisms that Schefold (2004) addresses to Garegnanis approach, although the former correctly

points out a similarity between the latter and Clowers (1969) formulation of the microeconomic

foundations of Keyness aggregate demand function.

Ttonnement Pricing Revisited 527

This reduced form of model (1)(6) has only one intertemporal relative price,

the rate rb. The auctioneer will call a higher (lower) contemporary price, pa0,

if and only if he finds a positive (negative) excess physical demand E a0(p).

Instead he will call a higher (lower) rate rb if and only if he finds that the

value of the aggregate demand for investment exceeds (falls short of) the

value of the aggregate supply of saving. That aggregate excess demand at

current values is paoE a0(p) + pboE b0(p).

Let H a, H b be smooth sign-preserving functions of excess demands, with

H a(0) = H b(0) = 0. Then the following differential equations determine the

ttonnement dynamics for the whole economy:

dpa 0

= H a (E a 0 (p))

dt

(15)

drb

= H b ( pa 0 E a 0 (p) + E b0 (p))

dt

Given the initial prices, p(t), t = 0, a path p(t), t > 0, is determined by the

differential equations (15). The paths of the remaining current and intertem-

poral prices follow from the relations between current prices and discounted

prices and from the price equations (1), (10) with the numeraire equations

pb1 = 1 and Pb1 = 1. The corresponding path of the excess demand for labour

E L( P) follows from Walrass law (14).

The heterodox ttonnement of equations (15) can be compared with the

orthodox ttonnement of equations (9). The excess of aggregate investment

over aggregate saving plays a causal role in (15) and ultimately reflects the

role of the demand for a value of capital (flow) even in a model with het-

erogeneous physical capital goods, whereas it does not intervene in (9).10 As

a consequence, the proofs of existence and uniqueness of equilibrium are not

affected, but we should abandon the standard proofs of stability because

Jevons law imposes (15) instead of (9). In the next section we shall present

an example in which a well-established method of proving global stability

fails if we move from (9) to (15).

10

Assuming that the price of a certain commodity reacts not only to the excess demand for that

commodity but also to the excess demand for other commodities is not a novel approach in sta-

bility analysis. In particular, the application of Newtons method of numerical analysis pre-

scribes that the price of each commodity reacts to the excess demand for all commodities by a

certain uniform coefficient and brings about a proportional decrease in all excess demands (see

Smale, 1976). However, the specific feature of the adjustment described by (14) is the fact that

an intertemporal price reacts to the value of the excess demands for capital flows.

528 Sergio Parrinello

AND STABILITY

Assume that the sign-preserving functions of excess demands are the iden-

tity function. The complete system of differential equations is:

= E a 0 (p), = pa 0 E a 0 (p) + E b0 (p), = E L (p) (15)

dt dt dt

method. Choose as the Liapunov function the square of the Euclidean

distance from equilibrium:

2 2 2

V ( pa 0 , rb , w1 ) = ( pa 0 - pae 0 ) + (rb - rbe ) + (w1 - w1e )

dV dp dr dw

= 2 ( pa 0 - pae 0 ) a 0 + (rb - rbe ) b + (w1 - w1e ) 1

dt dt dt dt

dV

= 2[( pa 0 - pae 0 )E a 0 (p) + (rb - rbe )( pa 0 E a 0 (p) + E b0 (p)) + (w1 - w1e )E L (p)]

dt

(1 + rb)E b0(p) + w1E L(p) 0

dV

= -2[( pae 0 + rbe pa 0 )E a 0 (p) + (1 + rbe )E b0 (p) + w1e E L (p)]

dt

dV (p e )

If p = pe is an equilibrium price vector, then = 0 . The expression in

dt

square brackets can be written

(16)

+ rbe ( pa 0 - pae 0 )E a 0 (p)

dV (p)

If Z is positive, < 0 and the equilibrium is stable.

dt

Ttonnement Pricing Revisited 529

Let us assume that the demand functions satisfy the weak axiom of

revealed preferences (in particular that the goods are gross substitutes). Then

the term in square brackets in (16) is positive for any non-equilibrium price

vector. The axiom assures11 the uniqueness of equilibrium and its global sta-

bility within the orthodox ttonnement (9). However, the same axiom does

not imply that Z is positive, because the term rbe(pa0 - pea0)Ea0(p) in (16) may

be negative and its sign may prevail. In two cases the axiom would imply a

positive Z. First, if we assume pa0 = pea0, i.e. if the price of commodity a avail-

able at t = 0 is kept at its equilibrium level, the possible negative term disap-

pears. Second, assuming reb > 0, if (pa0 - pea0) and Ea0(p) have the same sign,

reb(pa0 - pea0)Ea0(p) is positive. The first case is uninteresting; the second is not

plausible, because it requires that any price above (below) its equilibrium level

is associated with a positive (negative) excess demand for the corresponding

good.

The analytical case examined in this section does not furnish proofs of sta-

bility or instability, but it helps to locate the specific difficulty for the theory

of intertemporal equilibrium. We have not proved a case of unstable equi-

librium, relatively to the heterodox ttonnement, and we have not excluded

that a different Liapunov function can be found in order to prove stability.

We have not proved either that an equilibrium, which is unstable under the

orthodox ttonnement, a fortiori is unstable under the heterodox one.

Furthermore we should be aware that more complicated adjustment

processes (e.g. processes with trading at false prices) may be stable and some

counter-intuitive results may turn up, as Franklin Fisher (1983) has reminded

us with regard to the passage from the traditional ttonnement to more real-

istic stability processes, where the convergence depends not only on the prop-

erties of the excess demand functions, E, but also on those of the reactions

functions, H. However, we have shown that the weak axiom of revealed pref-

erences, combined with the usual Liapunov function, does not allow us to

prove that an intertemporal equilibrium is stable within the adjustment

context which is consistent with Jevonss law. This negative result depends on

the fact that certain properties, which the excess demand functions for

individual commodities are supposed to satisfy (in our case gross substi-

tutability), do not imply definite properties of the excess demand function

for an aggregate capital flow. We shall expand on this issue in the final

section.

11

See Arrow et al. (1959).

530 Sergio Parrinello

equilibrium, although it is formulated as a disaggregated model by taking the

physical endowments instead of their total value as given, is not protected

from the intrusion of a demand and supply of an aggregate value and its

ensuing difficulties. The role of aggregate capital flows emerges from the dif-

ferential equations (15) or (15), although it is absent in the determination of

an equilibrium solution to equations (1), (6) and in the traditional tton-

nement (9). Therefore, the problem of the demand and supply for aggregate

capital reappears. The present case is different from the problem of capital

which was at the centre of the two Cambridges debate of the 1960s only

because the dimensions of the magnitudes at issue are different: the flow

dimension of investment and saving versus the stock dimension of the

demand and supply of capital. Badly behaved saving and investment

functions can be met in a model with many heterogeneous capital goods and

may become a specific source of non-meaningful equilibria for the same

reasons. The general conclusion is that this source is related to capital and

time.

It might be objected that leading general equilibrium theorists, such as

Arrow, Debreu, Franklin Fisher and Hahn, were well aware of the limita-

tions of the orthodox ttonnement pricing, especially in the case of constant

returns to scale, and that a wide literature which deals with more realistic

non-ttonnement adjustment processes literature is now available.12 There-

fore, it might be contended that our criticism would hit a too limited target.

We reply, following the argument of section 4, that the assumption of an

economy subject to arbitrage and the corresponding difficulties for the

stability properties of intertemporal equilibrium are not confined to the

assumption of constant returns. Under decreasing returns to scale, we can

deal with well-defined supply functions consistent with profit maximization,

but the problem of a uniform effective rate of return on capital would not

be eliminated from the ttonnement pricing. We surmise that those leading

economists, when they were engaged with the stability analysis of the

orthodox ttonnement, were not aware of the causal role of a demand and

supply of aggregate capital in their general equilibrium models characterized

by heterogeneous capital goods. We leave up to other contributions the onus

probandi that alternative rules of non-ttonnement pricing have not to

assign the role of causal determinants to some aggregate value of capital

goods.

12

I owe this remark to the comment of a referee.

Ttonnement Pricing Revisited 531

REFERENCES

Arrow, K. J., Block, H. D., Hurwicz, L. (1959): On the stability of competitive equilibrium, II,

Econometrica, 27, pp. 82109.

Clower, R. W. (1969): The Keynesian counterrevolution: a theoretical appraisal, in Clower, R.

W. (ed.): Monetary Theory. Penguin, Harmondsworth.

Fisher, F. (1983): Disequilibrium Foundations of Equilibrium Economics, Econometric Society

Publication no. 6, Cambridge University Press.

Garegnani, P. (2003): Savings, investment and capital in a system of general intertemporal equi-

librium (with 2 appendices and a mathematical note by M. Tucci, in Petri, F., Hahn, F. H.

(eds): General Equilibrium. Problems and Prospects. Routledge, London (2003)). Earlier

version in Kurz, H. D. (ed.): Critical Essays on Sraffas Legacy in Economics. University

Press, Cambridge (2000).

Hahn, F. H. (1982): The neo-Ricardians, Cambridge Journal of Economics, 6, pp. 35374.

Schefold, B. (2003): Reswitching as a cause of instability of intertemporal equilibrium, Metroe-

conomica, 56 (4), pp. 43876.

Schefold, B. (2004): Saving, investment and capital in a system of general intertemporal equi-

libriuma comment on Garegnani, January, 4th version, mimeo.

Smale, S. (1976): A convergent process of price adjustments and global Newton Methods,

Journal of Mathematical Economics, 3, pp. 114.

Varian, H. (1992): Microeconomic Analysis, 3rd edn, Norton Co., New York, NY.

Universit di Roma La Sapienza

Via del Castro Laurenziano 9

00161 Roma

Italia

E-mail: sergio.parrinello@uniroma1.it

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