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A REAL INTERTEMPORAL MODEL WITH INVESTMENT

CHAPTER 11
Optimal Investment Rule

▶ The firm invests until the marginal benefit from investment is equal to the marginal cost

M B(I) = M C(I)
′ +1−d
M PK
=⇒ =1
1+r

=⇒ M PK −d=r
′ − d, is equal to the real
▶ The firm invests until the net marginal product of capital, M PK
interest rate.
▶ The net marginal product of capital, M PK ′ − d, is the marginal product of capital after

taking account of the depreciation of the capital stock.


▶ The optimal investment schedule is the firm’s net marginal product of capital, as a
function of investment, given the initial quantity of capital K.

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Optimal Investment Schedule for the Representative Firm

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Shifts in the Optimal Investment Schedule

The optimal investment schedule shifts due to any factor that changes the future marginal
product of capital:
1. The optimal investment schedule shifts to the right if future total factor productivity z ′
increases.
▶ Recall that an increase in total factor productivity increases the marginal product of
capital, for each level of the capital stock.
▶ Therefore, if total factor productivity is expected to be higher in the future, so that z ′
increases, this increases the future marginal product of capital, and the firm is more
willing to invest during the current period.
▶ Higher investment in the current period leads to higher future productive capacity, so that
the firm can take advantage of high future total factor productivity.

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Shifts in the Optimal Investment Schedule

The optimal investment schedule shifts due to any factor that changes the future marginal
product of capital:
2. The optimal investment schedule shifts to the left if the current capital stock K is higher.
▶ A higher capital stock at the beginning of the current period implies that for a given level
of current investment I, the future capital stock K ′ will be larger.
▶ That is, if K is larger, then there is more of this initial capital left after depreciation in
the current period to use in future production.
′ , will
▶ Therefore, higher K implies that the future marginal product of capital, M PK
decrease for each level of investment, and the optimal investment schedule will then shift
to the left.

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Volatility of Investment

▶ This theory of investment can potentially explain why aggregate investment expenditures
tend to be more variable over the business cycle than aggregate output or aggregate
consumption
▶ Investment behavior is not about smoothing but about the response of the firm’s
investment behavior to perceived marginal rates of return to investment.
▶ Investment is variable if the real interest rate is variable, causing movements along the
optimal investment schedule, or if there is variability in anticipated future total factor
productivity, causing the optimal investment schedule to shift over time.

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Government
▶ Government behavior is identical to what it was in Chapter 9.
▶ The government sets government purchases of consumption goods exogenously in each
period.
▶ The quantity of government purchases in the current period is G, and in the future
government purchases are G′ .
▶ The government finances government purchases in the current period through taxation
and by issuing government bonds.
▶ Then in the future, the government pays off the interest and principal on its bonds and
finances future government spending through future lump-sum taxation.
▶ The government must satisfy its present-value budget constraint:

G′ T′
G+ =T+
1+r 1+r

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Competitive Equilibrium

Equilibrium in this economy is defined as:


1 The representative consumer supplies labor in the current-period labor market, and
demands consumption goods in the current-period goods market.
2 The representative firm demands labor in the current period, supplies goods in the current
period, and demands investment goods in the current period.
3 Finally, the government demands goods in the current period, in terms of government
purchases.

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The Current Labor Market and the Output Supply Curve

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Determination of Equilibrium in the Labor Market Given the Real Interest
Rate r

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The Output Supply Curve

▶ The output supply curve describes how much output is supplied by firms for each possible
level for the real interest rate.
▶ As we vary the interest rate, the labor supply curve will shift, causing a change in
equilibrium employment and therefore equilibrium output.
▶ This allows us to construct a curve, called the output supply curve, which is an
upward-sloping curve consisting of all combinations of current output and real interest
rates, (Y , r), for which the current labor market is in equilibrium.
▶ The output supply curve slopes upward because of the intertemporal substitution effect
on labor supply.
▶ If the real interest rate is higher, the representative consumer will choose to supply more
labor, resulting in an increase in employment and output.

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Construction of the Output Supply Curve

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Shifts in the Output Supply Curve

▶ The output supply curve shifts either because of :


1 A shift in the current labor supply curve (not arising because of a change in the real interest
rate)
2 A shift in the current labor demand curve
3 A shift in the production function

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Shifts in the Output Supply Curve

▶ The output supply curve shifts either because of :


1 A shift in the current labor supply curve (not arising because of a change in the real interest
rate)
2 A shift in the current labor demand curve
3 A shift in the production function
▶ A change in lifetime wealth shifts the labor supply curve

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Shifts in the Output Supply Curve

▶ The output supply curve shifts either because of :


1 A shift in the current labor supply curve (not arising because of a change in the real interest
rate)
2 A shift in the current labor demand curve
3 A shift in the production function
▶ A change in lifetime wealth shifts the labor supply curve
▶ A change in either current total factor productivity or the current capital stock shifts the
labor demand curve and the production function.

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Shifts in Labor Supply
▶ Recall that a decrease in lifetime wealth reduces the consumer’s demand for current
leisure, due to an income effect, and so the consumer supplies more labor for any current
real wage.
▶ The key factor that can cause a reduction in lifetime wealth for the consumer is an
increase in government spending, either in the present or in the future.
▶ From the present-value government budget constraint, any increase in government
spending, either in the present or the future (i.e., an increase in G or G′ ) must be
reflected in an increase in the present value of taxes for the consumer
▶ Therefore, an increase in G, in G′ , or in both, results in an increase in the lifetime tax
burden for the representative consumer.
▶ This causes a shift to the right in the labor supply curve since there is a negative income
effect on current leisure.
▶ Equilibrium employment and therefore output rises, causing a shift in the output supply
curve
▶ Thus an increase in G or G′ shifts the labor supply curve and the output supply curve to
the right, because of the income effect on labor supply.
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Increase in Current or Future Government Spending

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Shifts in Labor Demand/Production Function

▶ Recall that an increase in total factor productivity or in the capital stock shifts the
production function up, because more output can be produced for any level of the labor
input
▶ The labor demand curve shifts to the right, because the marginal product of labor
increases.
▶ As a result, given the real interest rate, the equilibrium quantity of employment rises, and
therefore from the production function, output rises.
▶ This implies that the output supply curve must shift to the right.
▶ The results would be identical if there had been an increase in the current capital stock.
▶ Thus an increase in z or K causes the production function to shift up, the labor demand
curve to shift to the right, and the output supply curve to shift to the right.

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Increase in Current Total Factor Productivity

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The Current Goods Market and the Output Demand Curve
▶ The total current demand for goods Y d is the sum of the demand for current
consumption goods by the representative consumer, the demand for investment goods by
the representative firm, and government purchases of current goods:

Y d = C d (r) + I d (r) + G

▶ We use the notation C d (r) and I d (r) to reflect how the demand for current consumption
goods and the demand for investment goods depend negatively on the real interest rate r.

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The Current Goods Market and the Output Demand Curve
▶ The total current demand for goods Y d is the sum of the demand for current
consumption goods by the representative consumer, the demand for investment goods by
the representative firm, and government purchases of current goods:

Y d = C d (r) + I d (r) + G

▶ We use the notation C d (r) and I d (r) to reflect how the demand for current consumption
goods and the demand for investment goods depend negatively on the real interest rate r.
▶ The demand for current consumption goods also depends on the lifetime wealth of the
representative consumer, one component of which is current income.
▶ The demands for investment goods and government purchases do not depend on
aggregate income
▶ So slope of the curve is the marginal propensity to consumer M P C

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The Current Goods Market and the Output Demand Curve
▶ The total current demand for goods Y d is the sum of the demand for current
consumption goods by the representative consumer, the demand for investment goods by
the representative firm, and government purchases of current goods:

Y d = C d (r) + I d (r) + G

▶ We use the notation C d (r) and I d (r) to reflect how the demand for current consumption
goods and the demand for investment goods depend negatively on the real interest rate r.
▶ The demand for current consumption goods also depends on the lifetime wealth of the
representative consumer, one component of which is current income.
▶ The demands for investment goods and government purchases do not depend on
aggregate income
▶ So slope of the curve is the marginal propensity to consumer M P C
▶ Equilibrium occurs where the demand for goods induced by the quantity of income Y is
just equal to Y.
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The Demand for Current Goods

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Construction of the Output Demand Curve

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Shifts in the Output Demand Curve

▶ The output demand curve depicts the level of current aggregate output demanded given
the real interest rate.

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Shifts in the Output Demand Curve

▶ The output demand curve depicts the level of current aggregate output demanded given
the real interest rate.
▶ The output demand curve can shift because of:
1 Shift in the demand for current consumption goods C d (r)
2 Shift in the demand for investment goods I d (r)
3 Change in the current quantity of government purchases G

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Increase in Government Spending

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Shifts in the Output Demand Curve
Other factors that shift output demand curve to the right in a similar way are:
1 A decrease in the present value of taxes

A decrease in the present value of taxes is caused by a reduction in current taxes, future
taxes, or both.
When this happens, the lifetime wealth of the representative consumer rises, and therefore
the demand for consumption goods, C d (r), increases, which causes a shift to the right in the
output demand curve.

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Shifts in the Output Demand Curve
Other factors that shift output demand curve to the right in a similar way are:
1 A decrease in the present value of taxes

A decrease in the present value of taxes is caused by a reduction in current taxes, future
taxes, or both.
When this happens, the lifetime wealth of the representative consumer rises, and therefore
the demand for consumption goods, C d (r), increases, which causes a shift to the right in the
output demand curve.
2 An increase in future income Y ′
If the representative consumer anticipates that his or her future income will be higher, then
lifetime wealth increases, resulting in an increase in the demand for current consumption
goods, C d (r).

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Shifts in the Output Demand Curve
Other factors that shift output demand curve to the right in a similar way are:
1 A decrease in the present value of taxes

A decrease in the present value of taxes is caused by a reduction in current taxes, future
taxes, or both.
When this happens, the lifetime wealth of the representative consumer rises, and therefore
the demand for consumption goods, C d (r), increases, which causes a shift to the right in the
output demand curve.
2 An increase in future income Y ′
If the representative consumer anticipates that his or her future income will be higher, then
lifetime wealth increases, resulting in an increase in the demand for current consumption
goods, C d (r).
3 An increase in future total factor productivity z ′
If the representative firm expects total factor productivity to be higher in the future, this
increases the firm’s demand for goods, so that I d (r) increases.

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Shifts in the Output Demand Curve
Other factors that shift output demand curve to the right in a similar way are:
1 A decrease in the present value of taxes

A decrease in the present value of taxes is caused by a reduction in current taxes, future
taxes, or both.
When this happens, the lifetime wealth of the representative consumer rises, and therefore
the demand for consumption goods, C d (r), increases, which causes a shift to the right in the
output demand curve.
2 An increase in future income Y ′
If the representative consumer anticipates that his or her future income will be higher, then
lifetime wealth increases, resulting in an increase in the demand for current consumption
goods, C d (r).
3 An increase in future total factor productivity z ′
If the representative firm expects total factor productivity to be higher in the future, this
increases the firm’s demand for goods, so that I d (r) increases.
4 A decrease in the current capital stock K
When there is a lower current capital stock, perhaps because of destruction, then the
demand for investment goods, I d (r), increases for each r.
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The Complete Real Inter-temporal Model

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