A Simple Two-Period Model with Investment

Luisa Lambertini
Macro-Finance

1 Adding Investment

We now modify our model to allow for investment and assume that output is produced using
capital. More precisely, output in period 1 is

y1 = f (k1 ), (1)

where y1 is output, k1 is the stock of capital existing at the beginning of period 1 and f (k)
is the production function. We are going to assume that production increases with capital
but subject to diminishing marginal productivity, namely

f 0 (k) > 0 and f 00 (k) < 0.

Furthermore, output cannot be produced without capital, so f (0) = 0.

A unit of capital is created from a unit of the consumption good. This process can be
reversed, so that a unit of capital can be eaten after it has been used as capital. While
this isn’t a very realistic assumption, it allows us to deal easily with capital. The implicit
assumption behind this is that the relative price of capital, namely the price of capital in
terms of consumption, is always equal to one.

The initial stock of capital is given. Hence, in our simple two-period model, the existing
stock of capital is k1 and it is given. During period 1, the stock of capital can be increased
(decreased) through investment (disinvestment). More precisely

k2 = k1 + i1 , (2)

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where i1 is investment in period 1 and it can be positive or negative. Similarly

k3 = k2 + i2 , (3)

where i2 is investment in period 2.

We are going to assume that the representative consumer is also the representative pro-
ducer in this economy. This means that, in each period, the representative consumer must
decide how much to invest. The period 1 budget constraint of the representative individual
is
f (k1 ) = c1 + i1 + b2 , (4)

where b2 is lending abroad and we have assumed that b1 = 0. The period 2 budget constraint
is
c2 + i2 = f (k2 ) + b2 (1 + r), (5)

where f (k2 ) is output produced in period 2 and we have assumed that b3 = 0.

We can solve (4) for b2 and substitute it into (5) to find the lifetime budget constraint
for the representative individual with investment
f (k2 ) c2 + i2
f (k1 ) + = c1 + i 1 + . (6)
1+r 1+r
The present value of consumption plus investment must be equal to the present value of
output.

In our economy the representative agent lives two periods and maximizes lifetime utility
U1 = u(c1 ) + βu(c2 ). Since the everything ends in period 2, a rational agent would not want
to carry capital past period 2, namely k3 = 0. Plugging this into (3) we find that

i2 = −k2 . (7)

In words, after using k2 to produce output y2 , a rational agent consumes k2 because there is
no point in ending lifetime with a positive stock of capital.

We are now ready to solve the maximization problem of the representative individual.

max u(c1 ) + βu(c2 ) (8)

c1 ,c2 ,i1

f (k2 ) c2 − k 2
subject to f (k1 ) + = c1 + i1 +
1+r 1+r

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 and k2 = k1 + i1 and k1 given

We can substitute for k2 , so that we only keep one constraint. The lagrangian associated to
(8) is given by
" #
f (k1 + i1 ) c2 − k1 − i1
max L = u(c1 ) + βu(c2 ) + λ f (k1 ) + − c1 − i1 − . (9)
c1 ,c2 ,i1 ,λ 1+r 1+r

The first-order condition relative to c1 , c2 , i1 , λ are

u0 (c1 ) − λ = 0, (10)

λ
βu0 (c2 ) − = 0, (11)
1+r
f 0 (k2 )
" #
1
λ −1+ = 0, (12)
1+r 1+r
f (k1 + i1 ) c2 − k1 − i1
f (k1 ) + − c1 − i 1 − = 0. (13)
1+r 1+r
We have already seen (10), (11) and (13) and will not discuss them further. The new first-
order condition here is (12), which simplifies to

f 0 (k2 ) = r. (14)

The equation above says that period 1 investment should continue until its marginal return
is equal to the marginal return of lending abroad, r. Intuitively, the representative agent
has two alternatives. He can lend abroad and get the rate of return r. Alternatively, he
can invest domestically and get the rate of return of f 0 (k2 ). Only when f 0 (k2 ) = r the
representative agent is indifferent among the two alternatives. An important implication
of (14) is that the optimal investment choice is independent of the country’s endowment
and consumption preferences. Why? Because in a world with perfect international capital
markets the representative agent can borrow from abroad at the rate r and invest domestically
up to the point where the marginal return to capital is exactly equal to r.

We can introduce investment and production in our diagram of intertemporal consump-

tion choices. The PPF (production possibility frontier) of the country describes the techno-
logical possibilities available in autarky for transforming period 1 consumption into period 2
consumption. In autarky,
i1 = f (k1 ) − c1 ,

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 c2 = f (k1 + i1 ) + k1 + i1 .

Hence, the PPF is

c2 + c1 = f (k1 + f (k1 ) − c1 ) + k1 + f (k1 ). (15)

If agents want to consume the most they can in period 1 in autarky, then c1 = f (k1 ) + k1
and then c2 = 0. Alternatively, they can consume nothing in period 1 and invest everything
in i1 so that c2 = f (k1 + f (k1 )) + k1 + f (k1 ). These two points are the extremes of the PPF
in figure 2. In between these points, the slope of the PPF is

∂c2
= − [1 + f 0 (k2 )] .
∂c1

Diminishing marginal productivity of capital makes the PPF strictly concave. Point A is the
autarky equilibrium, where the PPF is tangent to the highest indifference curve the economy
can reach without trade with the rest of the world. The slope of the two curves at point A
is −(1 + rA ), the gross autarky interest rate – see part 1 of the notes.

Let’s consider now the small open economy facing a world interest rate r < rA . Thus,
at A the marginal domestic investment project offers a rate of return above the world cost
of borrowing. Hence, it is optimal to trade across periods and invest and produce more, at
point B rather than A. Point B maximizes the present value of domestic output by placing
the economy on the highest feasible budget line at world prices. Given the budget constraint
of the country, consuming at point C gives the highest utility level the country can afford.

The current account in period 1 is

CA1 = b2 − b1 = f (k1 ) − c1 − i1 ,

which is the distance between point C and B. National saving is

s1 = f (k1 ) − c1 .

Putting the two together it is easy to see that

CA1 = s1 − i1 ,

namely national saving in excess of domestic capital formation flows into net foreign asset
accumulation.

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2 Adding Investment and Government Consumption

What if we add government consumption? This is going to affect our graph by: a) shifting
the PPF and the lifetime budget constraint vertically down by the size of g2 ; b) shifting the
PPF and the lifetime budget constraint horizontally leftward by the size of g1 .

Consider an economy that is initially with CA1 = 0 and let’s introduce government
spending in period 1, namely g1 > 0, g2 = 0. Notice that the first-order condition relative to i1
is still (12), which implies that period 1 investment is still the same. Now the production point
is B’, consumption point is C’, and the current account is the horizontal distance between B’
and C’, with CA1 < 0. Notice that government consumption in period 1 generates a current
account deficit, reduces both c1 and c2 , actually, with β(1 + r) = 1, both consumption levels
fall by the same amount. See Figure 2.

3 An Example

Let y = k α , with 0 < α < 1, and let u(c) = log c. The maximization problem is
(k1 + i1 )α
" #
c2 − k1 − i1
max L = log c1 + β log c2 + λ k1α + − c1 − i 1 − , (16)
c1 ,c2 ,i1 ,λ 1+r 1+r
with k1 given. The first-order conditions relative to c1 , c2 , i1 , λ are
1
− λ = 0, (17)
c1
β λ
− = 0, (18)
c2 1 + r
αk2α−1
" #
1
λ −1+ = 0, (19)
1+r 1+r
(k1 + i1 )α c2 − k1 − i1
k1α + − c1 − i1 − = 0. (20)
1+r 1+r
Let β(1 + r) = 1. Then
1 1
α 1−α α 1−α
   
αk2α−1 = r → k2 = → i1 = − k1 ,
r r
" #
1+r y2 + k1 + i1
c1 = c2 = y1 − i1 + ,
2+r 1+r
1
CA1 = b2 = [y1 − i1 − y2 − k1 − i1 ] .
2+r

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Figure 1:

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Figure 2: