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Finance, Economics, and Mathematics by Robert C. Merton, Oldrich A. Vasicek

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Chapter 10Introduction to Part III

General equilibrium models investigate the pricing of real and financial assets resulting from the balance of supply and demand in an economy. The participants in the economy (often called agents) make their investment and consumption decisions to optimize their individual objectives, typically the maximum expected utility of end-of-period wealth, or the maximum expected utility of lifetime consumption. This creates a demand and supply for transactions, whose pricing is then set by the equality of supply and demand.

Equilibrium is not a stationary state. It changes at every moment, depending on the stochastic nature of the flow of capital and goods, of investment results, and of technology changes.

One result obtained from the solution of a general equilibrium model is the relationship of interest rates to economic variables. Interest rates are determined by economic forces through the equilibrium of supply and demand. Term structure models describe the behavior of interest rates of different maturities as joint stochastic processes; these models do not relate interest rates to economic variables. General equilibrium models explain why interest rates behave the way they do, not just how they behave.

Most of the modern general equilibrium models fall into two broad categories: pure exchange models and production models. Pure exchange models assume that each participant receives some endowment (such as income from labor) during his lifetime, ...

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