Environment

We study an economy populated by a measure 1 of infinitely-lived investors (i.e, a continuum of investors

indexed on the interval [0, 1]), and who are identical at the beginning of each period. Investors value an
asset, w, that comes in supply Ω in the economy. We do not specify why they value the asset, but you can
picture the asset as machines that the investors can use to produce. Both the asset as well as real balances
(money), z, can be freely traded in a competitive market that takes places at the end of each period. The
asset is traded at price ϕ while real balances are traded at price 1 (this is normalized). You can think of
this market as a market where agents choose their portfolios for the next period, subject to some budget
constraint. In the literature, this market is often refered to as CM, for “competitive market.”
At the beginning of each period, each investor receives a random idiosyncratic shock that determines how
much he values the asset for the upcoming period. For simplicity, we assume that half of the investors receive
a high-valuation shock, while the other half receives a low-valuation shock. High-valuation investors value
holding a quantity w of assets with utility f h (w), while low-valuation agents receive utility f ℓ (w) ≤ f h (w).
This heterogeneity in how agents value the asset creates room for gains from trade: after realizing their
valuation shocks, low-valuation agents would like to sell some of their asset holdings to high-valuation
agents, which would be beneficial for the two parties. We give some agents the opportunity to benefit from
these gains from trade by allowing a fraction γ to engage in bilateral trade before the utility from holding
the asset is realized (and before the competitive market described earlier opens). In the literature this
market is usually referred to as DM, for “decentralized market.” Formally, a fraction γ of agents gets to
meet (randomly) with trading counterparts (high valuation with low valuation, and vice versa). In those
bilateral meetings, the quantity of asset traded and the trading price are determined by Nash bargaining.
The high-valuation agent (the asset buyer) has bargaining power θ, and the low-valuation agent (the asset
seller) has bargaining power 1 − θ.

DM CM
- receive valuation shock - competitive trade
- bilateral trade (portfolio choice)
- enjoy utility from asset
Figure 1: Timing of events within a period

Objective
Our goal is to solve for the general equilibrium in this economy, more precisely, we want to know: how much
asset holdings and money holdings, (w, z), will the agents choose to hold from one period to another? At
what price, ϕ, will the asset be traded in the competitive market?

To answer these questions, there are two main steps:

1. Solving for the terms of trade (quantity and price) between two investors in a bilateral meeting
2. Solving for the portfolio choice in the CM, taking as given the terms of trade the agents expect if they
get to trade in a bilateral meeting later on

Exercise 1: Studying the bilateral trades

For now, let’s focus on a DM meeting between a high-valuation and a low-valuation investors. The former
has a portfolio (wh , zh ) and the latter has a portfolio (wℓ , zℓ ). To solve for the terms of trade between the two

1
investors, we apply the Nash bargaining solution, which consists in maximizing the product of the agents’
surpluses from trading. The surplus from trading corresponds to what the agent earns if the trade goes
through net of what the agent would earn if the agents did not trade. The problem is
{ }θ { ℓ }1−θ
max f h (wh + y) − f h (wh ) + ϕy − p f (wℓ − y) − f ℓ (wℓ ) − ϕy + p (1)
p,y

subject to
− wh ≤ y ≤ wℓ (2)
− zℓ ≤ p ≤ z h , (3)
where y is the quantity of asset traded and p is the price. (You should make sure you understand where
the two constraints come from.) The left-most term is the high-valuation investor’s surplus, the right-most
term is the low-valuation investor’s surplus.

Denote y ∗ (wh , wℓ ) the trade size that maximizes the gains from trade, i.e, f h′ (wh +y ∗[) = f ℓ′ (wℓ −y ∗ ). The ]
outcome
[ ℓ of this maximization problem
] is y = y ∗ (wh , wℓ ) and p = p∗ (wh , wℓ , ϕ) ≡ (1−θ) f h (wh + y ∗ ) − f h (wh ) + ϕy ∗ −
θ f (wℓ − y ∗ ) − f ℓ (wℓ ) − ϕy ∗ if p∗ ≤ zh , and
[ ]
(1 − θ) f ℓ′ (wℓ − y) + ϕ [ h ]
p(y; wh , wℓ , ϕ) = f (wh + y) − f h (wh ) + ϕy
(1 − θ) [f (wℓ − y) + ϕ] + θ [f (wh + y) + ϕ]
ℓ′ h′
[ ] (4)
θ f h′ (wh + y) + ϕ [ ℓ ]
− f (wℓ − y) − f (wℓ ) − ϕy
ℓ
(1 − θ) [f ℓ′ (wℓ − y) + ϕ] + θ [f h′ (wh + y) + ϕ]

y = p−1 (zh ; wh , wℓ , ϕ) (5)

otherwise. As a result, we can write the high-valuation investor’s surplus as
{
f h (wh + p−1 (zh )) − f h (wh ) + ϕp−1 (zh ) − zh if zh ≤ p∗
uh = [ ] (6)
θ f h (wh + y ∗ ) − f h (wh ) + f ℓ (wℓ − y ∗ ) − f ℓ (wℓ ) otherwise.

The low-valuation investor’s surplus is

{
zh + f ℓ (wℓ − p−1 (zh )) − f ℓ (wℓ ) − ϕp−1 (zh ) if zh ≤ p∗
uℓ = [ ] (7)
(1 − θ) f h (wh + y ∗ ) − f h (wh ) + f ℓ (wℓ − y ∗ ) − f ℓ (wℓ ) otherwise.

Q1. Check the bargaining solution and the surpluses.

Q2. Compute and plot the surpluses, uh and uℓ , as functions of zh , wh , and wℓ . Use θ = 0.5, f h (y) =
f ℓ (y) = y 1−σ /(1 − σ), σ ∈ {0.01, 0.05, 0.1, 0.2, 0.5, 0.7, 0.9}. To do this, you need to take ϕ as given, so you
can choose whatever is most convenient. Make sure that the constraints (2) and (3) always hold. The way
I wrote the solution, you should never be in a situation where y > wℓ or p > zh , but for some parameter
values you may get y < −wh or p < −zℓ (this may happen when the low-valuation agent wants to buy assets
from the high-valuation agent). For now the best is to avoid these zones.