You are on page 1of 18

Metroeconomica 56:4 (2005) 514531



Sergio Parrinello*
University of Rome La Sapienza
(March 2004; revised August 2004)


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


Expanding the dimensions of the commodity space has been a typical

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

of the static general equilibrium can be directly extended to such a

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
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

Blackwell Publishing Ltd 2005

516 Sergio Parrinello



Let us formulate a simplified version of the intertemporal equilibrium model

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

Pa1 = l aW1 + aa Pa 0 + ba Pb0

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)

where L is a given supply of labour.

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

Blackwell Publishing Ltd 2005

Ttonnement Pricing Revisited 517

A1 = Da1 ()
B1 = Db1 ()

where Da1(), Db1() are demand functions for consumption of goods a, b at

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)

One among the seven equations (1)-(2)-(3)-(4) depends on the others;

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

S0 () [A0 - Da 0 ()]Pa 0 + [B0 - Db0 ()]Pb0

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

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

Blackwell Publishing Ltd 2005

518 Sergio Parrinello

demand function after substitution of Pa1, Pb1 in Djt(). The corresponding

excess demand functions are

E a 0 (P) d a 0 (P) + aa d a1 (P) + a b d b1 (P) - A0

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 E functions are positively homogeneous of degree zero in P and satisfy

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)):

Pa 0 E a 0 (P) + Pb0 E b0 (P) +W1E L (P) 0 (8)

Let us remain within the limits of adjustment processes with ttonnement.

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

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.

Blackwell Publishing Ltd 2005

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
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

pa1 = l a w1 + (aa pa 0 + ba pb0 )(1 + rb )

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

Equations (10)3 can be written

pa1 - l a w1 pa 0 - l a w0
= 1 + rb
pa 0 - l a w0 aa pa 0 + ba pb0
pb1 - l bw1 pb0 - l bw0
= 1 + rb
pb0 - l bw0 a b pa 0 + bb pb0

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

Blackwell Publishing Ltd 2005

520 Sergio Parrinello

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

Blackwell Publishing Ltd 2005

Ttonnement Pricing Revisited 521

Pa1 Pb0 Pa 0 Pb0 (11)

Pb1 Pa 0 Pa1 Pb1

which apparently seems to be an identity. This is not the correct interpreta-

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

(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.


Following Schefolds (2004) reconstruction of the microfoundations of

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

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.

Blackwell Publishing Ltd 2005

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
(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

The attribute perfect substitutes in the intertemporal context at issue does

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

See Varian (1992, section 7.2).
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.

Blackwell Publishing Ltd 2005

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

ca*0 - a0 , cb*0 - b0 , ca*1, cb*1, l* = l

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.

Blackwell Publishing Ltd 2005

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).

What can the auctioneer cry?

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

Blackwell Publishing Ltd 2005

Ttonnement Pricing Revisited 525

which should be met by the auctioneer under the assumption of constant

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:

P10 Pn0 , P20 Pn0 , . . . , Pn-1,0 Pn0

P11 Pn1 , P21 Pn1 , . . . , Pn-1,1 Pn1 ,W1 Pn1
P1T PnT , P2 T PnT , . . . , Pn-1,T PnT ,WT PnT

and T intertemporal relative prices (own rates of interests) of the good

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

Pn0 Pn,1 , Pn1 Pn,2 . . . , Pn,T -1 Pn,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.

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.

Blackwell Publishing Ltd 2005

526 Sergio Parrinello

Instead a change in an intertemporal price of the good chosen as the

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).


Let us formulate the excess demands as functions of current prices and of

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 a 0 (p) da 0 (p) + aa da1 (p) + a b db1 (p) - A0

E b0 (p) db0 (p) + ba da1 (p) + bb db1 (p) - B0
E L (p) l a da1 (p) + l b db1 (p) - L

The E functions satisfy the Walrass law written in terms of capitalized

current prices:

(1 + rb ) pa 0 E a 0 (p) + (1 + rb )E b0 (p) + w1E L (p) 0 (14)

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.

Blackwell Publishing Ltd 2005

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

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).

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.

Blackwell Publishing Ltd 2005

528 Sergio Parrinello



Assume that the sign-preserving functions of excess demands are the iden-
tity function. The complete system of differential equations is:

dpa 0 drb dw1

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

Let us try to extend the stability analysis based on Liapunovs second

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 )

where pea0, reb, w1e are equilibrium prices. Then

dV dp dr dw
= 2 ( pa 0 - pae 0 ) a 0 + (rb - rbe ) b + (w1 - w1e ) 1
dt dt dt dt

by substitution of the time derivatives with (15)

= 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)]

by substitution of w1E L(p) from Walras identity (1 + rb)pa0E a0(p) +

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

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

dV (p e )
If p = pe is an equilibrium price vector, then = 0 . The expression in
square brackets can be written

Z [(1 + rbe ) pae 0 E a 0 (p) + (1 + rbe )E b0 (p) + w1e E L (p)]

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

dV (p)
If Z is positive, < 0 and the equilibrium is stable.

Blackwell Publishing Ltd 2005

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
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

See Arrow et al. (1959).

Blackwell Publishing Ltd 2005

530 Sergio Parrinello


Garegnanis (2003) criticism has a foundation: the theory of intertemporal

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
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

I owe this remark to the comment of a referee.

Blackwell Publishing Ltd 2005

Ttonnement Pricing Revisited 531


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.

Facolt di Economia e Commercio

Universit di Roma La Sapienza
Via del Castro Laurenziano 9
00161 Roma

Blackwell Publishing Ltd 2005