How Shocks Affect Markets: A Novel Dynamical Macroeconomic Model to Explain Adjustment of Markets and Equilibria

Objective: Most macroeconomic models are based on representative agents with identical preferences for all consumers and production technology for all producers, i.e., an assumption too simplistic if not unrealistic to model the real world. Similarly, the models revolve around a general equilibrium for all markets which seldom exists in a dynamic and rapidly changing and evolving world where shocks keep happening too frequently to imagine all markets to stay put in an economy. There is a lack of robustness of macroeconomic models with respect to inflexible assumptions they are based on (including but not limited to specific structural forms for utility functions and production technology). This paper provides a foundation stone for a more realistic macroeconomic modeling based on practical behavior of economic agents with minimum number of assumptions without use of specific and complex structural forms as compared to those in the existing literature. Methods: This paper captures an interaction of three markets, i.e., goods, labor, and capital. Dynamic optimization problems of agents in all three markets have been solved to find expressions regarding their individual decisions, which have been solved simultaneously to get a nonhomogeneous linear system of differential equations, for which conditions for a unique solution has been specified. Also, conditions regarding stability and existence of an equilibrium have been stipulated. Results: It provides results which are robust to heterogeneous consumers and producers exhibiting bounded rationality. It models macroeconomy based on easily measurable empirical components. After estimating and substituting empirical parameter values in the system of differential equations and solving them, the response of three markets can be predicted. The model captures not only both initial and final sets of equilibria before and after shocks to all markets, rather it predicts the full adjustment path of all markets from initial to final equilibriums after various kinds of shocks happen to one or more markets. Conclusions: Optimal policies, such as monetary policy, taxation, inflation control, employment, trade, remittances, etc., affecting one or more of the three markets subject to relevant constraints can be derived based on a system of differential equations. The methodology employed for three markets can be extended to n number of markets in an economy.