Chapter 7 (11)

A Real Intertemporal
Model with
Investment

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Chapter 11 Topics

Construct a real intertemporal model that

will serve as a basis for studying money
and business cycles in Chapters 12-14.
Understand the investment decision of the
firm.
Show how macroeconomic shocks affect
the economy.
Focus on the implications of future
expectations for current macroeconomic
performance.
2
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Real Intertemporal Model

Current and future periods.

Representative Consumer work/leisure
& consumption/savings decisions
Representative Firm hires labour and
invests in current period, hires labour in
future
Government spends and taxes in present
and future, and borrows on the credit
market. 3
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Representative Consumers
Budget Constraints

Consumers current-period budget

constraint:
C S p w(h l ) T
Consumers future-period budget
constraint:
C ' w' (h l ' ) 'T '(1 r ) S p

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Consumers Lifetime Budget
Constraint

C' w' (h l ' ) 'T '

C w(h l ) T
1 r 1 r

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Marginal Conditions for the
Consumer

Current period:
MRSl ,C w
Future period:
MRSl ',C ' w'
Intertemporal Choice:
MRSC ,C ' 1 r

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Consumers Current Labour
Supply Behaviour

Current labour supplied increases with the

real wage (substitution effects are
assumed to dominate income effects).
Labour supply increases with an increase
in the real interest rate, through an
intertemporal substitution effect.
An increase in lifetime wealth (e.g. taxes
fall) reduces labour supply.

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The Representative Consumers
Current Labour Supply Curve

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An Increase in the Real Interest Rate
Shifts the Current Labour Supply Curve to
the Right

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Effects of an Increase in Lifetime
Wealth

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Firms Current and Future
Production Technology

Y zF ( K , N )
Y ' z' F (K ' , N ' )

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Evolution of the Firms Capital
Stock

K ' (1 d ) K I

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Firms Current and Future
Profits

Y wN I

' Y ' w' N '(1 d ) K '

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The Firm Maximizes the Present
Value of Profits

'
V
1 r

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The Firms Labour Demand

As in Chapter 4, the firms labour

demand schedule is the marginal
product of labour for the firm, which is
downward sloping.

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The Demand Curve for Current Labour Is
the Representative Firms Marginal
Product of Labour Schedule

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The Current Demand Curve for Labour Shifts Due
to Changes in Current Total Factor Productivity z
and in the Current Capital Stock K

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The Representative Firms
Investment Decision

The firm invests to the point where the

marginal benefit from investment
equals the marginal cost.

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Marginal Cost of Investment

The marginal cost of investment is 1, as

the firm gives up one unit of current
profits for each unit it invests, so:

MC( I ) 1

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Marginal Benefit of Investment

The marginal benefit of investment is

the marginal product of future capital
plus the quantity of capital that will be
left in the future after depreciation, all
discounted back to the present:
MPK' 1 d
MB( I )
1 r

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Optimal Investment Rule for the Firm

The firms optimal investment rule,

obtained by equating the marginal
benefit and marginal cost of
investment:

MP d r
'
K

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Optimal Investment Schedule for
the Representative Firm

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The Optimal Investment Schedule Shifts to the
Right if Current Capital Decreases or Future Total
Factor Productivity Is Expected to Increase

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The Governments Present-
Value Budget Constraint

G' T'
G T
1 r 1 r

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

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Construction of the Output Supply
Curve

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An Increase in Current or Future
Government Spending Shifts the Ys
Curve

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An Increase in Current Total Factor
Productivity Shifts the Ys Curve

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The Demand for Goods

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

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The Marginal Propensity to
Consume

MPC = the increase in the demand for

consumption goods induced by a
one-unit increase in current income.

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Derivation of the Output Demand
Curve

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What Shifts the Output Demand
Curve to the Right?
A decrease in the present value of
taxes.
An increase in future income.
An increase in future total factor
productivity.
A decrease in the current capital
stock.

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The Complete Real Intertemporal
Model

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Experiments Using the Real
Intertemporal Model
G increases temporarily (stimulus, the
multiplier, and crowding out)
K decreases (capital destruction)
z increases.
z increases (news about the future)

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Increase in G, Current
Government Spending

How much does the Yd curve shift to

the right?

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 Shift in the Yd curve

Expenditure multiplier = 1.
Given that the present value of taxes
rises by an amount equivalent to the
increase in current government
spending, the total increase in the
demand for goods, including the effect
on consumption, is equal to the
increase in G.
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Equilibrium Effects of the Increase in G

Output increases, real interest rate

increases, real wage falls,
consumption and investment
decrease, employment rises.
Government spending crowds out
both consumption and investment.

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Equilibrium Effects of the Increase in G

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Important Points

The total multiplier the ratio of the

equilibrium increase in Y, to the increase in
G must be less than 1.
In rudimentary Keynesian analysis, the
multiplier is greater than 1. Why?
-That type of analysis does not take account
of: (i) how the extra output is to be produced;
(ii) the effect of taxes (present and future) on
consumption.

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 Important Points

Extra government spending comes at a cost

crowds out private consumption and
investment spending, and we all have to
work harder.

In rudimentary Keynesian analysis,

increases in G are costless in fact Y and C
increase as a result. The conclusion seems
to be that G should be infinitely large
obviously silly.
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A Decrease in the Current
Capital Stock

This could arise due to a war or natural

disaster.
Output may rise or fall, depending on how
large the output demand effect is relative to
the output supply effect.

The real interest rate rises, the real wage

falls, employment may rise or fall.

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A Decrease in the Current
Capital Stock

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Current Total Factor Productivity
Increases

Real interest rate falls, consumption

and investment rise, employment
rises, real wage rises.

Productivity shocks are a potential

explanation for business cycles see
Chapter 13.

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The Equilibrium Effects of an
Increase in Current Total Factor
Productivity

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Total Factor Productivity Expected
to Increase in Future A News
Shock
Output demand curve shifts right.
Real interest rate rises, investment
increases, consumption may rise or
fall, employment rises, real wage falls,
output rises.
Important in explaining investment
boom in the 1990s in the United
States.
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The Equilibrium Effects of an
Increase in Future Total Factor
Productivity

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