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ECON 325 (5)
Chapter 11


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ECON 325
Sadik Arouba

A Real Intertemporal Model with Investment For the economy as a whole, investment represents a trade-off between present consumption and future consumption. Productive capacity that is used for producing investment goods could otherwise be used for producing current consumption goods. However, investment today increases the production of future consumption goods (future productive capacity is increased). Microeconomic investment behavior of a firm is studied in order to understand the determinants of investment. When a firm invests, it forgoes current profits in order to have a higher future capital stock, which will enable the firm to earn higher future profits. As a firm invests more: ● the lower its current capital stock ● the higher its future total factor productivity ● the higher the real interest rate Real interest rate represents investment’s opportunity cost (a higher real interest rate implies a large opportunity cost for investment, therefore investment falls). Also, investment decisions of firms depend on credit market risk as perceived by lenders. If lenders in the credit market view lending to be risky, then it will be more difficult for firms to borrow in order to finance investment. Representative Consumer: ThePcurrent period budget constraint for the consumer: c+s = w (h-l)+ -T……………………….(1) The future period budget constraint for the consumer is: c= w(h-l)+ -T+(1+r)s …………………(2) P From eqn(1), s = w(h-l)+ -T…………….(3) Substitute (3) into (2) c=w(h-l)+’ ’-T(1+r)s …………………….(4) ❑ ❑ c+ ❑ = w(h-l)+ -T+ ❑ ……………(5) Eqn (5) is the consumer’s lifetime budget constraint and it states that the present value of future consumption is equal to the present value of lifetime disposable income. The representative consumer’s problem is choos c,c,l and l’ ’ subject to the lifetime budget constraint. Consumer’s optimal decisions: ● MRS =l,c(in general a consumer optimizes by setting the marginal rate of substitution of one good for another equal to the relative price of the two goods, w is the relative price of leisure in terms of consumption goods). ● MRS l ,cw ’ ● MRS =c,cr (that is the marginal rate of substitution of current consumption for future consumption equals the relative price of current consumption in terms of future consumption) The relative price of good x in terms of good y is the number of units of y that trade for a unit of x. Current Labor Supply Interaction between consumers and the firm in the current labor market and current consumption goods market (that is, determinants of a consumer’s demand for current consumption goods and a consumer’s supply of labor). A consumer’s current labor supply is deteSmined by: ● the current real wage (current N increases as the current real wage increases) ● real interest rate ● lifetime wealth MRS =l,ccaptures the idea that the substitution of current leisure for current consumption is captured by the current real wage. Recall, that a change in the real wage has opposing income and substitution effects on the quantity of leisure. An increase in the real wage could increase or decrease the quantity of leisure depending on the size of the income effect. However, for this model, we assume that the substitution effect is larger than the income effect such that an increase in the real wage causes leisure to decrease and the number of hours worked increase. https://www.boundless.com/economics/consumer-choice-and- behavior/additional-topics/an-analysis-of-the-effect-of-wages-on-labor- supply/ https://docs.google.com/a/terpmail.umd.edu/document/d/15qUckbjCz164- vBVsp2h5DLDZKhLk2E9sxX2nljMZI0/edit# The quantity of current labor supplied increases when the real interest rate increases. A consumer can substitute intertemporally by substituting current consumption for future consumption, but also by substituting current leisure for future leisure. In substituting leisure , consumer responds to the current price of leisure relative to the future price of leisure, ❑ . ❑ In this case, w is the price of current leisure in terms of current consumption, w is the price of future leisure in terms of future consumption, and 1+r is the price of current consumption in terms of future consumption. Therefore, an increase in r given w, and w increases the relative price of current leisure in terms of future leisure. If the substitution effect is greater than the income effect, a consumer wants to consume less current leisure and more future leisure . Therefore, when r increases, and the substitution effect dominates the income effect. N decreases as lifetime wealth increases. An increase in current nonwage disposable income results in an increase in the quantity of leisure and a decrease in the quantity of labor supply. In the intertemporal case, an increase in lifetime wealth increases current and future consumption. However, in this case, when there is an increase in lifetime wealth there is an increase in current leisure, and therefore a decrease in current labor supply. A key wealth effect is the effect o
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