A REAL INTERTEMPORAL MODEL WITH INVESTMENT

CHAPTER 11
The Complete Real Inter-temporal Model

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The Equilibrium Effects of a Temporary Increase in G

▶ Suppose there is a temporary increase in government spending in the current period G

▶ Future government purchases, G′ , remain unchanged.
▶ When would the government choose to increase its expenditures on goods and services
temporarily?
▶ An important example is a war.
▶ Another example of an explicitly temporary change in government spending was the
spending program contained in the American Recovery and Reinvestment Act (ARRA) of
2009.
▶ A more recent example is the American Rescue Plan Act 2021, also called the Covid-19
Stimulus Package

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The Equilibrium Effects of a Temporary Increase in G

▶ Suppose that government spending in the current period increases from G1 to G2

▶ We would first like to determine how large the resulting shift in the output demand curve
will be.
▶ For convenience, assume that the marginal propensity to consume, MPC, is a constant
▶ This will imply that the shift to the right in the output demand curve, which we will
denote by ∆, will be the same for any real interest rate r.

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The Equilibrium Effects of a Temporary Increase in G
▶ The quantity ∆ is the total change in the demand for goods, which will come from three
sources:
1 The direct effect of the change in government spending, G2 − G1
2 The effect on consumption from the increase in taxes (in the present or the future) required
to finance the government spending increase
3 The effect on consumption from the increase in ∆, which the representative consumer will
see as an increase in income
▶ For determining the second effect:
From the present-value government budget constraint, the increase in the present value of
taxes for the consumer must be equal to G2 − G1
So the effect on the demand for consumption goods will be −M P C(G2 − G1 ), since the
marginal propensity to consume tells us how much the demand for consumption goods
changes with a one-unit change in lifetime wealth.
▶ For determining the third effect:
The change in demand for consumption goods is M P C∆, since an increase in current
income of ∆ units increases the demand for consumption goods by M P C∆ units.

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The Equilibrium Effects of a Temporary Increase in G
▶ Then the total increase in demand for goods is determined by:
∆ = G2 − G1 − M P C(G2 − G1 ) + M P C∆
▶ Note that ∆ appears on both sides of the equation, because an increase in ∆, through its
effect on the demand for consumption goods, produces more demand for consumption
goods—a multiplier effect
▶ How large is that multiplier?
▶ Solving the equation, we get:
∆ = G2 − G 1
▶ Let md denote the demand multiplier, which is the ratio of ∆ to the increase in
government expenditure
G2 − G1
md = =1
G2 − G1
▶ Total demand for goods increases by exactly the amount of the increase in government
spending, and the shift to the right in the output demand curve is also the increase in
government spending, G2 − G1 .
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The Equilibrium Effects of a Temporary Increase in G

▶ When G increases, this will have two effects, one on output supply and one on output
demand.
▶ We have determined the effect on output demand, which is a shift to the right in the
output demand curve, where the horizontal shift is equal to the increase in G.
▶ Since lifetime wealth decreases due to the increase in the present value of taxes, leisure
will decrease (leisure is a normal good) for the representative consumer, given the current
real wage, and so the labor supply curve shifts to the right, and the output supply curve
also shifts to the right .
▶ Since both output demand and output supply curves shift to the right, current aggregate
output Y must increase.

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The Equilibrium Effects of a Temporary Increase in G

▶ It may appear that the real interest rate may rise or fall; however, there is strong
theoretical support for an increase in the real interest rate.
▶ This is because the temporary increase in government spending should lead to only a
small decrease in lifetime wealth for the consumer, which will produce a small effect on
labor supply.
▶ Therefore, there should be only a small shift to the right in the Y s curve.
▶ Since shift in output demand must be larger than the shift in output supply, the real
interest rate must rise.

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A Temporary Increase in Government Purchases

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Total government expenditure multiplier

▶ Total government expenditure multiplier: The ratio of the equilibrium increase in real
output to the increase in government spending
▶ Since the output demand curve shifted to the right by the increase in government
spending, the equilibrium increase in current output must be less than the increase in
government spending.
▶ The total multiplier is less than 1
▶ It will become smaller as:
1 The size of the wealth effect on labor supply falls (this makes the rightward shift in the
output supply curve smaller)
2 The intertemporal substitution effect of the real interest rate on labor supply falls (this
makes the output supply curve steeper)

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Keynesian Economics
▶ In basic Keynesian analysis, each dollar spent by the government increases GDP by more
than one dollar, which implies that the total government expenditure multiplier is larger
than one
▶ Our analysis makes clear that the multiplier must be smaller than one, that government
spending comes at a cost, and that the capacity of the government to increase GDP is
limited.
▶ Keynesian ideas are based on the notion that price and wage inflexibility causes the
economy to behave differently in the short run than it does in the long run.
▶ A Keynesian might view the analysis done in this chapter as being applicable only to the
long run where prices and wages are flexible.
▶ However, many modern macroeconomists argue that price and wage inflexibility is
unimportant for the behavior of the macroeconomy, and that analysis based on optimal
choice by consumers and firms in equilibrium is the appropriate approach to analyzing
both short-run and long-run macroeconomic problems.
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Effect on Consumption and Investment
▶ What happens to current consumption?
▶ If the real interest rate did not change in equilibrium (e.g., if the output supply curves
were horizontal), we know from the figure that real income would increase by an amount
equal to the increase in government spending.
▶ If this occurred, then the change in the consumer’s lifetime wealth would be zero, since
the increase in the present value of taxes is equal to the increase in current income.
▶ As a result, current consumption would be unchanged.
▶ However, in our case, the real interest rate rises in equilibrium, so the representative
consumer will substitute future consumption for current consumption, and therefore
current consumption declines.
▶ Investment expenditures must also decrease because of the increase in the real interest
rate.
▶ Thus, both components of private expenditure (current consumption and investment) are
crowded out by current government expenditure.
▶ In the one period model studied in chapter 5, government expenditure crowded out only
consumption expenditure.
▶ Here, since government spending is shown here
A REAL INTERTEMPORAL MODELto crowd
WITH out private investment
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Increase in Output

▶ On the demand side of the goods market, it is the crowding out of private consumption
and investment expenditure that causes the total government expenditure multiplier to be
less than one here.
▶ On the supply side, output increases because of two effects on labor supply:
1 There is a negative wealth effect on leisure from the increase in lifetime tax liabilities.
2 The increase in the real interest rate makes future leisure cheaper relative to current leisure,
and there is a further increase in labor supply.
▶ Basic Keynesian analysis neglects both the crowding-out effects and the effects on the
supply side of the goods market.

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Effect of Decrease in Interest Rate

▶ The next step is to work through the effects of the increase in the real interest rate for
the labor market.
▶ Given the initial interest rate r1 , the labor supply curve shifts from N1s (r1 ) to N2s (r1 ),
because of the negative wealth effect arising from the increase in the present value of
taxes.
▶ With an increase in the equilibrium real interest rate to r2 , the labor supply curve shifts
further to the right, to N2s (r2).
▶ Therefore, the equilibrium real wage falls from w1 to w2 .

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A Temporary Increase in Government Purchases

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Conclusion

▶ What this analysis tells us is that increased temporary government spending, although it
leads to higher aggregate output, comes at a cost.
▶ With higher current government spending, the representative consumer consumes less and
takes less leisure, and he or she also faces a lower real wage rate.
▶ Further, current investment spending is lower, which implies that the capital stock will be
lower in the future, and the future capacity of the economy for producing goods will be
lower.

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The Equilibrium Effects of a Decrease in the Current Capital Stock K

▶ Over time, through investment, a nation adds to its capital stock

▶ This generally occurs slowly, as investment expenditure is typically quite small relative to
the total capital stock.
▶ Thus, increases in capital do not contribute much to short-run fluctuations in aggregate
output and employment.
▶ However, sometimes major reductions in the aggregate capital stock occur over a short
period of time.
▶ For example, a war can leave a country with a much lower capital stock, as happened due
to bombing in Germany, Great Britain, and Japan during World War II, and in Vietnam
during the Vietnam War.
▶ The capital stock can also be reduced because of natural disasters such as floods and
hurricanes.

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The Equilibrium Effects of a Decrease in the Current Capital Stock K
▶ Suppose that the representative firm begins the current period with a lower capital stock
K.
▶ This affects both the supply and the demand for output.
▶ First, a decrease in K from K1 to K2 decreases the current marginal product of labor,
which shifts the current demand for labor curve to the left
▶ The output supply curve then shifts to the left
▶ Second, a decrease in K increases investment by the firm, because the future marginal
product of capital will be higher.
▶ This shifts the output demand curve to the right
▶ The result is that, in equilibrium, the real interest rate must rise from r1 to r2
▶ The effect on current aggregate output is ambiguous, depending on whether the output
supply effect is larger or smaller than the output demand effect.
▶ In the figure, we have drawn the case where the output supply effect dominates, so that
current real output falls.
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The Equilibrium Effects of a Decrease in the Current Capital Stock

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Effect on Consumption and Investment

▶ In our figure, current consumption must fall, because the real interest rate has increased.
▶ The effects on investment appear to be ambiguous, because the decrease in K causes
investment to increase, while the increase in the equilibrium real interest rate causes
investment to fall.
▶ However, investment must rise, because less capital would otherwise cause
ever-decreasing investment, which would be inconsistent with the fact that the marginal
product of capital rises as the quantity of capital falls.
▶ In other words, as the quantity of capital falls, the marginal product of capital rises,
making the return on investment very high, so that ultimately investment must increase if
the capital stock decreases.

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Effect on employment and wages

▶ Because of the increase in the real interest rate, there is intertemporal substitution of
leisure, with the representative consumer working harder in the current period for each
current real wage w.
▶ Therefore, the labor supply curve shifts to the right
▶ This reinforces the effect of the increase in labor demand on the real wage, and so the
real wage must fall, from w1 to w2 .
▶ The equilibrium effect on the quantity of labor is ambiguous, because the effect on labor
demand and on labor supply work in opposite directions on the quantity of employment.
▶ In our figure, we show employment falling from N1 to N2 .

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Effect on output

▶ Now, suppose that we interpret these results in terms of the macroeconomic effects of a
natural disaster or a war that destroys part of the nation’s capital stock.
▶ The model shows that there are two effects on the quantity of output.
▶ The lower quantity of capital implies that less output can be produced for a given
quantity of labor input, which tends to reduce output.
▶ However, the lower quantity of capital acts to increase investment to replace the
destroyed capital, which tends to increase output.
▶ Theoretically, it is not clear whether output increases or decreases, and there appear to be
empirical cases in which the output supply and output demand effects roughly cancel, for
example during and after large natural disasters such as the Mississippi floods in 1993,
and Hurricane Katrina in 2005 or the 2004 Indian ocean tsunami.

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The Equilibrium Effects of an Increase in Current Total Factor
Productivity z
▶ Temporary changes in total factor productivity are an important candidate as a cause of
business cycles.
▶ The experiment we examine here in our real intertemporal model is to increase current
total factor productivity z
▶ If current total factor productivity increases, the marginal product of labor goes up for
each quantity of labor input
▶ So the demand for labor curve shifts to the right
▶ Therefore, the output supply curve shifts to the right
▶ In equilibrium the quantity of output rises and the real interest rate must fall, from r1 to
r2 .
▶ The decrease in the real interest rate leads to increases in both consumption and
investment.

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The Equilibrium Effects of an Increase in Current Total Factor Productivity

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Effect on employment and wages

▶ In the labor market, the decrease in the real interest rate causes intertemporal
substitution of leisure between the current and future periods, with current leisure
increasing, and so the labor supply curve shifts to the left
▶ In equilibrium, the real wage must increase from w1 to w2
▶ However, the net effect on the equilibrium quantity of employment is ambiguous.
▶ Empirically, however, the effect of the real interest rate on labor supply is small and as in
our figure, employment rises from N1 to N2 .

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Effect on output

▶ When total factor productivity increases, this increases the current demand for labor,
which raises the market real wage.
▶ With the real wage increase, workers are willing to supply more labor, employment
increases, and output increases.
▶ In the goods market, the increased supply of goods decreases the market real interest
rate, which results in an increased demand for investment goods and consumption goods,
so that the demand for goods rises to meet the increased supply of goods on the market.
▶ Further, the increase in current income increases consumption.

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Business Cycle
▶ From Chapter 3, recall that some key business cycle facts are that consumption,
investment, employment, the real wage, and average labor productivity are procyclical.
▶ Our real intertemporal model predicts these comovements in the data if the economy
receives temporary shocks to total factor productivity.
▶ That is, because our figure predicts that a temporary increase in total factor productivity
increases aggregate output, consumption, investment, employment, and the real wage,
the model predicts that consumption, investment, employment, and the real wage are
procyclical, just as in the data.
▶ Further, the average product of labor must be higher when z increases, provided that N
does not increase too much.
▶ In principle, average labor productivity could fall if N were to increase sufficiently in
response to the increase in z, but this does not happen in quantitative versions of this
type of model.
▶ Recall from Chapter 3 that the procyclicality of the average product of the labor is one of
our business cycle facts.
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The Effect on Average Labor Productivity of an Increase in z.

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The Equilibrium Effects of an Increase in Future Total Factor Productivity
z′

▶ The anticipation of future events can have important macroeconomic consequences in the
present, as when an increase in total factor productivity is expected to happen in the
future.
▶ For example, firms might learn of a new invention, such as the design for a new
production process, which is not available currently but will come on line in the future.
▶ News about future events and the influence of this news has played an important role in
macroeconomic theory.
▶ For example, Keynes had interest in the “animal spirits” of financial market investors and
the influence of swings in investor sentiment on economic activity.

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The Equilibrium Effects of an Increase in Future Total Factor Productivity
z′

▶ Indeed, the stock market represents a forum in which people take bets on the future
health of firms in the economy.
▶ Therefore, news which is informative about future productivity will tend to be reflected
first in stock prices.
▶ In financial market theory, stock prices are typically the reflection of the average stock
market participant’s views on firms’ future dividends, which are in good part determined
by the future total factor productivity of firms.
▶ Empirical research in macroeconomics supports the view that news about future events is
a key determinant of aggregate economic activity in the present.

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The Equilibrium Effects of an Increase in Future Total Factor Productivity
z′
▶ Suppose that everyone learns in the current period that z ′ will increase in the future.
▶ This implies that the future marginal product of capital increases for the representative
firm, and so the firm wishes to invest more in the current period
▶ This increases the demand for current goods, shifting the output demand curve to the
right
▶ In equilibrium, this implies that both aggregate output and the real interest rate increases
▶ The increase in the real interest rate then causes current consumption to fall
▶ but there is an opposing effect as consumption also tends to rise because of the increase
in current income and the anticipated increase in future income (because z ′ is expected to
increase).
▶ As a result, consumption could rise or fall.
▶ In equilibrium, there are two effects on investment; the increase in z ′ causes investment to
rise, and the increase in r causes it to fall.
▶ But investment must rise, as the initial shock to the economy works through a positive
effect on investment.
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The Equilibrium Effects of an Increase in Future Total Factor Productivity

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Effect on employment and wages

▶ What are the effects in the labor market?

▶ The increase in the real interest rate leads to a rightward shift of the labor supply curve
▶ Therefore, in equilibrium, the quantity of employment increases from N1 to N2 , and the
real wage falls from w1 to w2 .

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Conclusion

▶ In anticipation of a future increase in total factor productivity, firms increase investment

expenditure, as the marginal payoff to having a higher future capital stock has increased.
▶ The increase in the demand for investment goods raises the market real interest rate,
which increases labor supply and employment and generates an increase in aggregate
output.
▶ The increase in labor supply causes the real wage to fall.

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