1. Slide 1 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. A Real Intertemporal Model with Investment Chapter 7

2. Slide 2 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Already Done Consumer Behavior: Work-Leisure choices (CHAPTER 4) Intertemporal Consumption-Savings choices (CHAPTER 6) Production Side: Firms’ Production Technology and Labor Demand (CHAPTER 4) Changes in Productivity affect c, E and y. (CHAPTER 5) Government Side: Government expenditure and the timing of taxes.

3. Slide 3 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. To do: REAL Model REAL INTERTEMPORAL MODEL: show how real aggregate output, real consumption, real investment, employment, real wage and the real interest rate are determined. CHAPTER 7: Investment behavior.

4. Slide 4 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Investment Behavior Determinants of Investment: Study the microeconomic investment behavior of the firm, which makes an intertemporal decision regarding investment in the current period. Forgoes current profits to have higher capital stock and higher profits in the future.

5. Slide 5 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Determinants of high Investment Lower capital stock. Higher expected future total factor productivity. Lower real interest rate. KEY: opportunity cost of Investment

6. Slide 6 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. STUDY Effects of: Government Spending Shock. Total Factor Productivity Shock. Capital Stock Shock.

7. Slide 7 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. MODEL Representative Consumer: Supply labor and demand goods. Representative Firm: Demand labor, supply goods and demand investment goods. Government: Demand goods for purchases.

8. Slide 8 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Consumer Budget CURRENT c + s = w (h-l) +  – T FUTURE c’ = w’ (h-l’) +  ’ – T’ + (1+r) s LIFETIME c + c’/1+r = w(h-l) +  – T + (w’(h-l’)+  ’–T’)/1+r

9. Slide 9 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Consumer Problem Choose c, c’, l and l’ Given w, w’, r, T and T’ Cannot depict this on a single graph, Solution: describe consumer decision in terms of THREE marginal conditions (Chapter 4 and 6)

10. Slide 10 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Three Marginal (Optimal) Decisions Work-leisure decision (CHAPTER 4): MRS l,c = w Substitution between l and c is determined by w Remember: Income/Substitution effects of a change in w Same in the future: MRS l’,c’ = w’ Consumption-Savings decision (CHAPTER 6): MRS c,c’ = 1 + r

11. Slide 11 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. NOTE w price of current leisure (labor) in terms of current c w’ price of future leisure in terms of future c’ 1+r price of current consumption in terms of future consumption w(1+r)/w’ current price of leisure relative to the future price of leisure

12. CONSUMER The Labor Supply

13. Slide 13 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-1 The Representative Consumer’s Current Labor Supply Curve Substitution Effect dominates Why? We care for the Short-Run. In the Long-Run, both effects cancel out

14. Slide 14 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-2 An Increase in the Real Interest Rate Shifts the Current Labor Supply Curve to the Right  r   price of current leisure relative to future leisure Intertemporal Substitution of leisure

15. Slide 15 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-3 Effects of an Increase in Lifetime Wealth because leisure is a normal good

16. CONSUMER The Demand for Goods Remember the FOUR games in chapter 6.

17. Slide 17 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-4 The Representative Consumer’s Current Demand for Consumption Goods Increases with Income GAME 6.I Consumption increases with income

18. Slide 18 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-5 An Increase in the Real Interest Rate from r 1 to r 2 Shifts the Demand for Consumption Goods Down Shifters are GAME 6.II GAME 6.IV y’ (+) and r (-)

19. THE FIRM THE DEMAND FOR LABOR THE INVESTMENT DECISION

20. Slide 20 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. The Firm Production and Investment Production Function Y = z F(K,N) Gross Investment I = K’ – K + d K Net Investment I N = K’ – K Note that K’ = (1 – d) K + I KNKN Y C for consumers I create future K’

21. Slide 21 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. The Firm’s Decision Maximize the Present Value of  by choosing N, N’ and I. i.e., max V = max [  +  ’/1+r ] Note that  = Y – wN – I  ’ = Y’ – w’N’ + (1 – d) K’

22. THE FIRM The Labor DEMAND

23. Slide 23 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-7 The Demand Curve for Current Labor Is the Representative Firm’s Marginal Product of Labor Schedule Market rate w MPN from the production function Optimal ConditionMPN = w

24. Slide 24 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-8 The Current Demand Curve for Labor Shifts Due to Changes in Current Total Factor Productivity z and in the Current Capital Stock K SHIFTERS: 1)z 2)K

25. THE FIRM The Investment Decision

26. Slide 26 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. The Investment Decision Marginal Cost = Marginal Benefit Marginal Cost = 1, an extra unit of Investment, reduces current profits by 1 unit, which reduces PV(profits) by 1. Marginal Benefit = (MPK’+1–d) / 1+r where MPK is the extra output from the extra unit of K and (1-d) is the left over K, all are discounted to the present.

27. Slide 27 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Continue Solve it MC = MB  OPTIMAL INVESTMENT RULE MPK’ – d = r Net Marginal Product K = real interest rate

28. Slide 28 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-9 Optimal Investment Schedule for the Representative Firm Optimal Decision MPK’ – d = r

29. Slide 29 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Remember For Labor Demand  relevant price is w Condition: MPN = w For Investment Demand  relevant price is r Condition: MPK’ – d = r

30. Slide 30 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-10 The Optimal Investment Schedule Shifts to the Right if Current Capital Decreases or Future Total Factor Productivity Is Expected to Increase Shifters: 1)z (+) 2)K (-) Extra: What will happen to the Optimal Investment Schedule if d changes?

31. Slide 31 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Table 7-1: Optimal Investment: A Numerical Example K = 10 trees, Y = 100 bushels of apples, d = 0.2, r = 5% The seeds of 1 bushel of apples yield 1 tree in the future 3 – 0.2 Find the Optimal number of trees in the future K’

32. GOVERNMENT

33. Slide 33 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Government Finances purchases through taxation and issuing bonds. The Present Value Budget G + G’/1+ r = T + T’/1+r

34. Slide 34 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Competitive Equilibrium BUILD THE MODEL The goods Market The labor Market

35. THE GOODS MARKET CONSTRUCT THE OUTPUT SUPPLY CURVE

36. Slide 36 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-11 Determination of Equilibrium in the Labor Market Given the Real Interest Rate r Consumer Firm L market clears  N *  Y Note that r is constant

37. Slide 37 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-12 Construction of the Output Supply Curve If r changes  N s shifts  N * Track the changes to r and Y Track the relation between r and Y Graph r and Y

38. Slide 38 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Shifts in the Output Supply Changes in Labor Supply  Lifetime Wealth  changes in G or G’ Changes in Labor Demand  z or K (Slide 24) Changes in the Production Function  z or K

39. Slide 39 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-13 An Increase in Current or Future Government Spending Shifts the Y s Curve  G   PV(T)   Wealth   Leisure   Labor Supply   N  Supply of Output for the same r  N   Y [On the SAME Production Function]

40. Slide 40 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-14 An Increase in Total Factor Productivity Shifts the Y s Curve  Z or  K   MPN   Labor Demand  N   Y [On NEW Production Function]  Supply of Output for the same r

41. THE GOODS MARKET CONSTRUCT THE OUTPUT DEMAND CURVE

42. Slide 42 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Total current Aggregate Income Y (-) (-) Y = C d (r) + I d (r) + G C d depends on r, Y (moving on) and Y’ (Slide 17, 18) I d depends on r (moving on), z and K (Slide 28 and 30)

43. Slide 43 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-15 The Demand for Current Goods Just added C to I and G

44. Slide 44 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-16 Construction of the Output Demand Curve  r   C   Y Track r and Y

45. Slide 45 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Shifts of the Demand for Output Changes in Consumption (C) Changes in Investment (I) Changes in Government (G) Note that anything that will shift C d, I d or G will also shift the Y d (see Slide 42)

46. Slide 46 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-17 The Output Demand Curve Shifts to the Right if Current Government Spending Increases  G   Wealth which  C by MPC    G    C   Y (b/c Y = C + I + G) Will  Y for the same r

47. THE COMPLETE MODEL

48. Slide 48 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-18 The Complete Real Intertemporal Model Wealth / r slide 14 z / K slide 24 C / I / G slides 42 / 45 N s / N d / z / K slide 38 SHIFTERS

49. Slide 49 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. THE ONLY GAME G, z, K C, N s, N d, Y, w, r Real Intertemporal Model

50. Slide 50 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Key Messages of the Chapter Permanent vs. Temporary shock Temporary: change in G Permanent: change in G and G’ Expected in the future shock

51. Slide 51 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-19 A Temporary Increase in Government Purchases  G   Labor Supply and  Output Supply SLIDE 39  G   C by MPC, therefore  Output Demand SLIDE 46 so that  r which  Labor Supply End-Result:  w  N  r  Y  IS IT A GOOD MODEL?

52. Slide 52 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-20 A Permanent Increase in Government Purchases  G   Labor Supply and  Output Supply SLIDE 39  G and  G’   C by MPC = 1, therefore NO CHANGE to Y d so that  r which  Labor Supply End-Result:  w  N  r  Y  IS IT A GOOD MODEL? Friedman’s

53. Slide 53 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Permanent vs. Temporary Government shock Temporary: change in G  CROWDING-OUT C and I Permanent: change in G and G’  NO CROWDING-OUT I  stronger crowding-out C (because strong wealth effect)

54. Slide 54 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-21 Natural Log of Real Investment, 1929-1998 Consistent with the Real Intertemporal Model predictions

55. Slide 55 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Real Interest Rate Model  r increases when G increases which crowds-out Investment. Data  Investment decreased during WWII  Did the r increase during WWII ?

56. Slide 56 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Real Interest Rate r  R – π r did not increase as predicted by the model

57. Slide 57 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Explanation So why did Investment decrease when the real interest rate decreased during WWII ?

58. Slide 58 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. The effects of a Decrease in K A natural disaster Cross-country comparison

59. Slide 59 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-22 The Equilibrium Effects of a Decrease in the Current Capital Stock  K   Labor Demand and  Output Supply  K   I because the MPK   Output Demand so that  r which  Labor Supply End-Result:  w  N  r  Y  C ?I

60. Slide 60 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-23 The Equilibrium Effects of an Increase in Current Total Factor Productivity  z   Labor Demand (MPN) and  Output Supply so that  r which  Labor Supply (small) End-Result:  w  N  r  Y  C  I

61. Slide 61 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Real Business Cycle Theory Temporary shocks to z are a candidate as a cause of business cycles Increases in the relative price of energy (decreases in total factor productivity)

62. Slide 62 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-25 Percentage Deviations from Trend in GDP for the United States

63. Slide 63 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-26 Percentage Deviations from Trend in Real Investment and Real GDP for the United States

64. Slide 64 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-27 Percentage Deviations from Trend in Employment and Real GDP for the United States

65. Slide 65 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-28 Percentage Deviations from Trend in Real Consumption and Real GDP for the United States

66. Slide 66 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Future Expectations Expected increase in z’  increases current investment, current output, current employment and reduces the real wage

67. Slide 67 Copyright © 2002 by O. Mikhail, Graphs are © by Pearson Education, Inc. Figure 7-29 The Equilibrium Effects of an Increase in Future Total Factor Productivity  z’   current Investment   Output Demand so that  r which  Labor Supply End-Result:  w  N  r  Y  C  I