A Real Intertemporal Model

with Investment

CHAPTER 11 - PART II
Learning objectives

• Define the competitive equilibrium in the two-period model

with investment.
• Derive the equilibrium conditions for
– the current period labour market
– the current period goods market
– the credit market
• Evaluate how changes in exogenous variables affect
– the labour demand schedule
– the labour supply schedule
– the output supply curve
– the output demand curve

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Two-period model with endogenous production:
Overview
• Two periods: the current and the future.
• Three types of agents:
– The representative consumer
– The representative firm
– The government
• The agents interact in the following markets
– The labour market in the current and future periods
– The goods market in the current and future periods
– The credit market in the current period

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Two-period model with endogenous production:
Overview
• Representative Consumer
– Makes work/leisure & consumption/savings decisions to
maximize the lifetime utility
• Representative Firm
– Hires labour in the current and future periods & invests in
the current period to maximize profits
• Government
– Provides public goods. Levies taxes and issues debt, but
satisfies the intertemporal budget constraint.

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Competitive equilibrium

• A competitive equilibrium is a set of quantities {C, C’, l, l’,

Ns, Ns’, Sp; Nd, Nd’, Id, Y, Y’, K’, π, π’, T, T’, B} and prices {w,
w’ and r} such that for any given values of {K, G, G’, z, z’}
– The consumer solves the utility maximization problem,
given the market prices;
– The firm solves the profit maximization problems, given
the market prices;
– The government satisfies the intertermporal budget
constraint;
– The prices adjust so that all markets are in equilibrium.

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We will focus on the competitive equilibrium in
the current period

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The competitive equilibrium in the current period
is summarized by two markets
• The labour market (given the real interest rate r)
– The labour supply schedule
– The labour demand schedule
– Equilibrium outcomes: N and w
• The goods market
– The output supply curve
– The output demand curve
– Equilibrium outcomes: Y and r

• The credit market clears by Walras’ law.

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The labour market in the current period

• The labour demand schedule tells how much labour the

representative firm wants to hire at any given wage rate.

– The labour demand is given by MPN = w.

• The labour supply schedule tells how much the
consumer is willing to work for any given wage rate
(keeping the real interest rate fixed at r).
– The labour supply is driven by the trade-offs between the
current consumption and current leisure and between current
and future leisure as well as by the intertemporal budget
constraint.

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The current period labour market equilibrium

• The labour demand curve has

a negative slope because MPN
is decreasing with N.
• The labour supply has a
positive slope under the
assumption that the
substitution effect dominates
the income effect.
• The labour market equilibrium
is obtained for the given value
of the real interest rate r.

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WORKSHEET: The labour market equilibrium

• What effect do the changes in the following exogenous

variables have on the labour demand schedule, the
labour supply schedule and the labour market
equilibrium employment and wage?
– An increase in z
– An increase in z
– An increase in G
– An increase in G’
– An increase in K

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WORKSHEET: The labour market equilibrium

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Equilibrium output, given
the real interest rate r

In panel (a), given r, the

intersection of the current
labour supply and labour
demand curves determine
the equilibrium real wage
w* and employment N*.

The production function in

panel (b) then determines
the aggregate output Y*

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The goods market in the current period

• The output supply curve is the locus of the

combinations of Y and r for which the labour market is
in equilibrium
• The output demand curve is the locus of the
combinations of Y and r for which the income balance
condition is met.
• The equilibrium in the goods market gives Y and r.

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 Construction of the
output supply curve
In panel (a), an increase in r
shifts the labour supply curve
to the right leading to an
increase in equilibrium
employment
Panel (b) implies an increase
in Y following an increase in r
Panel (c) shows the output
supply curve

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Shifts in the output supply curve
• Any exogenous factor that disturbs the labour market
equilibrium will affect the output supply curve.
• Three factors that shift the output supply curve
– Consumer’s lifetime wealth
– Current total factor productivity
– Current capital stock
• Changes in the lifetime wealth shift the labour supply
curve and therefore shift the output supply curve
• Changes in current total factor productivity or current
capital stock shift the production function and the labour
demand curve, and hence shift the output supply curve

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Effect of government spending on Ys

An increase in G or G' shifts the output supply curve to

the right because
• A) lifetime wealth increases, a positive income effect that shifts
labour supply to the right.
• B) lifetime wealth decreases, a negative income effect that shifts
labour supply to the left.
• C) lifetime wealth decreases, a negative income effect that shifts
labour supply to the right.
• D) the increase in the real interest rate shifts output supply.
• E) the decrease in the real interest rate shifts output supply.

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Effects of higher TFP on Ys
An increase in total factor productivity causes the
• A) production function to shift up, labour demand to shift right,
and output supply to shift right.
• B) production function to shift up, labour demand to shift left,
and output supply to shift right.
• C) production function to shift up, labour demand to shift right,
and output supply to shift left.
• D) production function to shift down, labour demand to shift
left, and output supply to shift left.
• E) production function to shift down, labour demand to shift
right, and output supply to shift right.

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An increase in G or G’

An increase in current or
future government
spending shifts the Ys curve
to the right

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An increase in z

An increase in current total

factor productivity shifts the
Ys curve to the right

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An increase in K

An increase in K shifts the

production function upward
This shifts the labour demand
curve and the output supply
curve to the right

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The demand for current goods

• The demand in the economy in the current period

consists of three components:
– the demand for goods from the representative consumer;
– the demand for investment from the representative firm;
– the demand for the public goods from the government.

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Demand for current consumption goods

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Demand for investment goods

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The total demand for current goods

• Total current aggregate demand Y is the sum of

– The demand for current consumption goods Cd(r)
– The demand for investment goods Id(r)
– Government purchases of current goods G
• Given r, the income balance condition determines
the equilibrium demand for current goods
– It is the aggregate income that generates the total demand for
goods just equal to that quantity of aggregate income

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The demand for current goods Y  C d
( r )  I d
(r )  G

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The marginal propensity to consume

• MPC = the increase in the demand for consumption

goods induced by a one-unit increase in current
income.

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The equilibrium demand for current goods

The equilibrium demand

for current goods, given
the real interest rate r, is
the aggregate income at
which
the Cd(r) + Id(r) + G
curve intersects the 45
degree line

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Derivation of the output demand curve

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Derivation of the output demand curve (continued)

• The figure on the previous slide illustrates the derivation

of the output demand curve
• In panel (a), an increase in r shifts the Cd(r) + Id(r) + G
curve down leading to a decrease in equilibrium demand
for current goods
• Panel (b) shows the output demand curve Yd, which is the
locus of the combinations of Y and r for which the income
balance condition is met

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WOKRSHEET: Which factors shift the output
demand curve to the right?
• A decrease in the present value of taxes.
• An increase in the future income.
• An increase in the future total factor productivity.
• A decrease in the current capital stock.

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Summary: The complete real intertemporal model

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