EC3102: Lecture Notes

Topic 06: Two-Period Model

(with Investment)
Aamir Raque Hashmi
National U of Singapore
February 13, 2012
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 1 / 63
Outline
Investment decision by rms
Work-leisure decision by consumers
Derivation of output supply curve
Derivation of output demand curve
Complete model of demand and supply (without money)
Eects of various shocks on the model economy
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 2 / 63
Real Intertemporal Model
Current and future periods
Representative consumer
consumption/saving decision
work/leisure decision
Representative rm hires labor and invests in the current period and
hires labor in the future period
Government spends and taxes in present and future and borrows on
the credit market
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 3 / 63
Equation 10.1
Consumers current-period budget constraint:
C +S
P
= w (h l ) + T
Y w (h l ) +
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 4 / 63
Equation 10.2
Consumers future-period budget constraint:
C
0
= w
0
_
h l
0
_
+
0
T
0
+ (1 +r ) S
P
Y
0
w
0
_
h l
0
_
+
0
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 5 / 63
Equation 10.3
Consumers life-time budget constraint:
C +
C
0
1 +r
= w (h l ) + T +
w
0
(h l
0
) +
0
T
0
1 +r
or
C +
C
0
1 +r
= Y T +
Y
0
T
0
1 +r
The choice variables for the consumer are: C, C
0
, I and I
0
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 6 / 63
Equation 10.4
Consumers current-period marginal condition:
MRS
l ,C
= w
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 7 / 63
Current-Period Marginal Condition
l
C
e
I
24 23
w
Figure: Slope of the budget constraint is w & of the indierence curve is MRS
l ,C
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 8 / 63
Equation 10.5
Consumers future-period marginal condition:
MRS
l
0
,C
0 = w
0
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 9 / 63
Equation 10.6
Consumers intertemporal marginal condition:
MRS
C,C
0 = 1 +r
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 10 / 63
Consumers Current Labor Supply
Current labor supplied increases with the real wage (substitution
eects are assumed to dominate income eects)
S.E.: With the same sacrice in leisure, the consumer can buy more
consumption. Consumpiton has become cheaper relative to leisure.
Hence the consumer will buy more consumption and less leisure
I.E.: The consumer feels richer and buys more of both consumption
and leisure
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 11 / 63
Figure 10.1: Representative Consumers Current Labor
Supply Curve
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 12 / 63
Consumers Current Labor Supply
Current labor supplied increases with an increase in the real interest
rate, through an intertemporal substitution eect
S.E.: Tomorrows leisure becomes cheaper (because price of
tomorrows leisure is
w
0
1+r
) so the consumer would like to have more
leisure tomorrow and less leisure today. Less leisure today means more
work today.
I.E.: It depends on whether the consumer is a borrower or a lender. A
borrower (with C > w (h l )) will feel poorer and would like to reduce
both l and l
0
and hence her labor supply will increase. A lender (with
C < w (h l )) will feel richer and would like to increase both l and l
0
and hence her labor supply will decrease.
We assume that the substitution eect is stronger than the income
eect for the lender.
With this assumption, an increase in r will increase current labor
supply.
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 13 / 63
Figure 10.2: Increase in the Real Interest Rate
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 14 / 63
Consumers Current Labor Supply
An increase in life-time wealth (e.g. a fall in taxes) reduces labor
supply
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 15 / 63
Figure 10.3: Increase in Lifetime Wealth
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 16 / 63
Consumers Current Demand for Consumption Goods
As current income (y) increases, current consumption (c) increases
The same relationship holds at the aggregate level
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Figure 10.4: Consumption Increases with Income
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 18 / 63
Increase in the Real Interest Rate
As the real interest rate increases, current consumption certainly
decreases for the borrowers
If we assume that the substitution eect is stronger than the income
eect then the current consumption also decreases for the lenders
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 19 / 63
Figure 10.5: Increase in the Real Interest Rate
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 20 / 63
Figure 10.6: Increase in Lifetime Wealth
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 21 / 63
Equation 10.7
Firms current-period production function:
Y = zF (K, N)
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 22 / 63
Equation 10.8
Firms future-period production function:
Y
0
= z
0
F
_
K
0
, N
0
_
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 23 / 63
Equation 10.9
Evolution of the rms capital stock:
K
0
= (1 d) K +I
where I (upper-case i ) is investment and d is the depreciation rate of
capital
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 24 / 63
Equation 10.10
Firms current-period prots:
= Y wN I
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 25 / 63
Equation 10.11
Firms future-period prots:

0
= Y
0
w
0
N
0
+ (1 d) K
0
The capital stock is K at the beginning of the rst period,
K
0
= (1 d) K +I at the end of the rst period and (1 d) K
0
at
the end of the second period
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 26 / 63
Equation 10.12
The rm maximizes the present value of prots:
V = +

0
1 +r
,
which can be written in an extended form as:
V = max
N, N
0
, I
_
zF (K, N) wN I +
1
1+r

_
z
0
F
_
_
(1 d) K +I
. .
K
0
, N
0
_
_
w
0
N
0
+
(1 d)
_
_
(1 d) K +I
. .
K
0
_
_
__
.
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 27 / 63
The Firms Labor Demand
The rms labor demand schedule is the marginal product of labor for
the rm, which is diminishing
To see this, nd the rst-order condition for N :
MP
N
=
zF (K, N)
N
= w
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 28 / 63
Figure 10.7: The Firms Labor Demand
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 29 / 63
The Firms Labor Demand
As z or K increase, MP
N
increases
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 30 / 63
Figure 10.8: The Eect of Increase in z or K on Labor
Demand
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 31 / 63
Equation 10.16: Firms Investment Decision
The rm invests to the point where the marginal benet from
investment equals the marginal cost
To see this, nd the rst-order condition for I :
1 +
1
1 +r
_

_
z
0
F (K
0
, N
0
)
K
0
. .
MP
K
0
K
0
I
..
1
+ (1 d)
_

_
= 0
=)
MP
K
0 d = r
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 32 / 63
Figure 10.9: Optimal Investment Schedule
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 33 / 63
Figure 10.10: The Eect of Increase in z or Decrease in K
on Investment Schedule
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 34 / 63
Shifts in Investment Schedule
It is obvious that as z
0
increases, MP
K
0 increases
To see the intuition for the inverse relationship between K and MP
K
0
suppose that initially the rm demands I
1
units of investment at rate of
interest r
Next assume that K
1
decreases to K
2
This implies that at I
1
, there will be too little future capital stock:
[(1 d) K
2
+I
1
] < [(1 d) K
1
+I
1
]
Given that MP
K
0 is diminishing, a lower K
0
will increase MP
K
0 relative
to the given rate of interest r
Hence, to satisfy the equilibrium condition, the rm must increase its
investment
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 35 / 63
Shifts in Investment Schedule: Increase in Default
Premium
Let x denote the default premium
The optimality condition for investment becomes:
MP
K
0 d = r +x.
Which can be rewritten as:
MP
K
0 d x = r .
This implies that an increase in default premium will reduce the
demand for investment at a given rate of interest
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 36 / 63
Figure 10.11: The Eect of Increase in Default Premium
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 37 / 63
Figure 10.12: Investment and the Interest Rate Spread
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 38 / 63
Figure 10.13: Investment and the Interest Rate Spread
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 39 / 63
Equation 10.18
The governments present-value budget constraint:
G +
G
0
1 +r
= T +
T
0
1 +r
.
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 40 / 63
Figure 10.14: Equilibrium in the Labor Market for a given
Real Interest Rate
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 41 / 63
Figure 10.15: The Output Supply Curve
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 42 / 63
Figure 10.16: Increase in Current or Future Government
Spending
As G or G
0
increases
T and/or T
0
increases (to balance the budget)
Lifetime wealth decreases
The consumer works more and hence labor supply increases
This is a supply-side eect of a change in G or G
0
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 43 / 63
Figure 10.16: Increase in G or G
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 44 / 63
Figure 10.16: Increase in z
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 45 / 63
Equation 10.19
So far it was the supply side
Now we move on to the demand side
Total demand for output is equal to the sum of demand for
consumption goods, demand for investment goods and demand for
goods from the government:
Y
d
= C
d
_
Y
d
, r
_
+I
d
(r ) +G.
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 46 / 63
Figure 10.18: Demand for Current Goods
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 47 / 63
Eect of Increase in Expenditure on Demand: The
Multiplier
An increase in expenditure leads to a more than one-for-one increase
in output:
Y
d
= MPC Y
d
+E.
=)
Y
d
=
1
1 MPC
. .
The Multiplier
E
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 48 / 63
Figure 10.19: Output Demand Curve
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 49 / 63
Figure 10.19: Output Demand Curve
This is the same as the IS curve
As r increases, the consumers consume less (credit card, durables on
instalments, house, car etc.) and they invest less
The story is: demand for credit is low hence the supply of credit
should also be low to clear the market. The supply of credit will be
low if the level of income is low
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 50 / 63
Figure 10.20: Shift in Output Demand Curve (Increase in
G)
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 51 / 63
Shifts in Output Demand Curve
An increase in G shifts the curve to the right
A decrease in taxes (working through consumption), an increase in
future productivity (working through investment) and a decrease in
current capital (working through investment) will also shift the curve
to the right
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 52 / 63
Figure 10.21: The Complete Real Intertemporal Model
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 53 / 63
Experiments using the Real Intertemporal Model
An increase in G [Figures (10.22) and (10.23)]
A decrease in K [Figure (10.24)]
An increase in z [Figure (10.25)]
An increase in z
0
[Figure (10.26)]
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 54 / 63
Figure 10.22: The Eect of an Increase in G on Demand
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 55 / 63
Figure 10.23: An Increase in G
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 56 / 63
Figure 10.23: An Increase in G
C +I +G curve shifts up =) Y
D
shifts to the right
T increases (life-time wealth decreases) and N
S
shifts to the right
Because of the shift in Y
D
, r goes up =) further increase in N
S
Increase in N
S
will shift the Y
S
curve to the right
Final outcome: employment increases; output increases, real wage
decreases; rate of interest increases, and investment declines
(crowding out). The eect on consumption is unclear
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 57 / 63
Figure 10.24: The Equilibrium Eect of a Decrease in K
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 58 / 63
A Decrease in K
Marginal product of labor declines (the same labor have to work with
less capital) and N
D
curve shifts to the left
For a given level of employment, output [Y = zF (K, N)] falls and
the production function shifts down
The output supply curve shifts to the left
The marginal product of K
0
increases and output demand curve shifts
to the right
The equilibrium real interest rate increases but the net eect on
equilibrium output is uncertain
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 59 / 63
Figure 10.25: The Equilibrium Eect of an Increase in z
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 60 / 63
An Increase in z
The marginal product of labor increases and the labor demand curve
shifts to the right
The same quantities of labor and capital produce more output and
hence the production function shifts up
The output supply curve shifts to the right
The equilibrium real interest rate will drop. This will shift the labor
supply curve to the left. However, we assume this eect to be small
The equilibrium output increases and real rate of interest decreases
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 61 / 63
Figure 10.26: The Equilibrium Eect of an Increase in z
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 62 / 63
An Increase in z
The marginal product of K
0
increases and the output demand curve
shifts to the right
The equilibrium output and real interest rate increase
The increase in real interest rate will shift the labor supply curve to
the right. Once again, we assume this eect to be small
Hashmi (National U of Singapore) Two-Period Model (Inv) February 13, 2012 63 / 63