Investment with

Adjustment
Costs and Govt
Budget
Constraints
The Firm’s Problem
What if firms experience adjustment costs
when they buy new machines and invest?
Consider a quadratic adjustment cost.
The firm maximizes the NPV of its profit stream
(value of output net of wage payments and
machine purchases) net of the adjustment
cost term.
Investment (I) in period t is the difference
between the capital stock (K) in period t+1
and the undepreciated portion of period t’s
capital stock.
Optimization
 
Stability
 
Implications
 
Keynesian vs Monetarist
Assumptions: Fiscal Policy
 
The govt budget constraint
 
Short run equilibrium
C is a function of Y+B-T (disposable income) and A, while
money demand depends on Y, r, and A. Both C and money
demand depend positively on A.
Using this in the IS-LM framework, total differentiation gives us
AD and r as functions of G, B, and M.
AD increases in G and M while its derivative w.r.t B is
ambiguous in sign, while r increases in G and B, with an
ambiguously signed derivative w.r.t M.
The short run effect of an increase in G is to shift the IS curve
out along the positively sloped LM curve: an excess demand
for money or excess supply of bonds drives up r, while Y also
increases.
Because of the budget constraint, this increase in G can be
financed either through issue of money or issue of bonds.
Financing through printing
money
 
Bond financing