A Real Intertemporal Model

with Investment

CHAPTER 11 - PART I
Learning objectives for Chapter 11

• Construct a real intertemporal model that will serve as

a basis for studying money and business cycles.
• Understand the investment decision of firms.
• Show how macroeconomic shocks affect the economy
in a dynamic model with production.
• Evaluate how future expectations affect current
economic decisions.

ECO 3152 1-2

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

ECO 3152 1-3

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.

ECO 3152 1-4

The government’s problem

• The government is modeled exactly as in Chapter 9.

• The government provides exogenous goods G and G’.
• The government raises taxes T and T’.
• The government deficit is financed by issuing bonds B.
• All debt must be repaid at the end of the second period.]
• The intertemporal budget constraint holds:

G' T'
G T 
1 r 1 r
ECO 3152 1-5
The problem of the representative firm

• What is the goal of the firm in the real intertemporal

model?

• How does the firm determine its optimal levels of

labour inputs and of investment?

• How is the optimal choice affected by changes in the

economic environment (shocks)?

ECO 3152 1-6

Production function: current period

• In the current period, the representative firm produces

output according to the production function
Y=zF(K,N),
where Y is current output, z is total factor productivity,
F is the production function, K is the current capital
stock, and N is the current labour input

ECO 3152 1-7

Production function: future period

• In the future period, output is produced according to

Y’=z’F(K’,N’),
where Y’ is future output, z’ is future total factor
productivity, K’ is the future capital stock, and N’ is the
future labour input

ECO 3152 1-8

Capital accumulation

• The firm begins the current period with K units of

capital (i.e. K is given)
• The initial capital stock changes for two reasons
– A fraction d of current capital K wears out through usage
– Investment I in the current period
• Thus, the future capital stock K’ is given by
K’ =(1-d) K+I

ECO 3152 1-9

The firm’s current and future profits

  Y  wN  I

 '  Y ' w' N ' (1  d ) K '

ECO 3152 1-10

The firm maximizes the present value of profits

• The firm’s problem is dynamic.

• The firm chooses its inputs and the level of investment
to maximize the present value of profits, subject to the
capital accumulation equation.

'
V  
1 r
ECO 3152 1-11
WORKSHEET:
The firm’s profit maximization problem
• Write down the firm’s objective function.
• Define the firm’s choice variables.
• Define the exogenous variables.
• Derive the firm’s demand for labour in the current and
future periods and the firm’s investment demand.

ECO 3152 1-12

WORKSHEET:
The firm’s profit maximization problem
• The
  firm maximizing the present value of profits by
selecting N, N’, I and K’, taking as given w, w’, r and z,
z’ and K.

• subject to K’ =(1-d) K+I

ECO 3152 1-13

The firm’s current and future profits

• π = Y- wN - I
π = zF(K,N)-wN-I

• π' = Y’- w’N’ + (1-d) K’

π' = z’F(K’,N’)-w’N’ + (1-d) K’
π' = z’F((1-d)K+I,N’)-w’N’ + (1-d) [(1-d)K+I]

ECO 3152 1-14

WORKSHEET:
The firm’s profit maximization problem
•  
• = zF(K,N)-wN-I +
• We have re-written the problem as an unconstrained
optimization problem, where the firm chooses N, N’, I.
• The first-order conditions are

ECO 3152 1-15

The labour demand in the current period

• =  zF(K,N)-wN-I +

• In selecting the current amount of labour, the firm looks at the

marginal revenues and marginal costs.

• => – w = 0

MPN = w

ECO 3152 1-16

The labour demand in the current period

• As in Chapter 4, the firm’s

labour demand schedule is the
marginal product of labour for
the firm.
• The labour demand curve is
downward sloping.

MPN = w

ECO 3152 1-17

 Factors that shift the labour demand curve

• Current total factor

productivity z
• The current capital stock K

• The labour demand curve

shifts to the right when
z↑ or K↑

ECO 3152 1-18

The labour demand in the future period

• =  zF(K,N)-wN-I +

• In selecting the current amount of labour, the firm looks at the

marginal revenues and marginal costs.

• => = 0

MP’N = w’

ECO 3152 1-19

The representative firm’s investment decision

• The firm invests to the point where

the marginal benefit from investment
= the marginal cost.

ECO 3152 1-20

Marginal cost of investment

• The marginal cost of investment is 1, as the firm gives

up one unit of current profits for each unit it invests.

MC(I) = 1

ECO 3152 1-21

Marginal benefit of investment

• The marginal benefit of investment is the marginal

product of future capital plus the quantity of capital
that will be left in the future after depreciation, all
discounted back to the present:

MP  1  d
'
MB ( I )  K
1 r

ECO 3152 1-22

The optimal investment rule

• The firm’s optimal investment rule is obtained by

equating the marginal benefit and marginal cost of
investment:

MC ( I )  1
MP  1  d
'
MB ( I )  K
1 r

ECO 3152 1-23

The labour demand in the future period

• =  zF(K,N)-wN-I +

• In deciding how much to invest, the firm looks at the marginal

revenues and marginal costs.
• => +(1-d)]=0

=1

ECO 3152 1-24

The optimal investment rule

• The firm’s optimal investment rule is obtained by

equating the marginal benefit and marginal cost of
investment:

MP  d  r
'
K

ECO 3152 1-25

The optimal investment rule

•  

• We can re-arrange the terms:

-d=r

ECO 3152 1-26

Investment demand schedule slopes down

MP  d  r
'
K

ECO 3152 1-27

Factors that shift the optimal investment
schedule
• The current capital K
• The future TFP z’

• The optimal investment

schedule shifts to the
right when K↓ or it is
expected that z’↑

ECO 3152 1-28

The representative consumer

• The representative consumer works and consumes in

the current and future periods
• In each period, she has h units of time which she
divides between work and leisure
• In the current period, the consumer earns real wage
income w(h – l), receives dividend income p, pays
taxes T, and consumes C units of goods and l units of
leisure
• In the future period, she earns real wage income
w’(h – l’), receives dividend income p’, pays taxes T’,
and consumes C’ units of goods and l’ units of leisure

ECO 3152 1-29

The consumer’s budget constraints

• Consumer’s current-period budget constraint:

C  S  w(h  l )    T
p

• Consumer’s future-period budget constraint:

C '  w' (h  l ' )   'T ' (1  r ) S p

• The representative consumer takes the current (future)

real wage w (w’) and the real interest rate r, as well as
profits and taxes as given

ECO 3152 1-30

The consumer’s lifetime budget constraint

C' w' (h  l ' )   'T '

C  w(h  l )    T 
1 r 1 r

• The representative consumer’s lifetime budget

constraint states that the present value of lifetime
consumption equals the present value of lifetime
disposable income

ECO 3152 1-31

Consumer’s optimization

• The consumer chooses C, C’, l, and l’ to make herself

as well off as possible (i.e. to attain the highest level of
utility) given the lifetime budget constraint.
• The representative consumer’s optimizing decision is
characterized by the three marginal conditions and the
intertemporal budget constraint.

ECO 3152 1-32

The consumer faces three trade-offs

• Current period:
MRSl ,C  w
• Future period:
MRSl ',C '  w'
• Intertemporal choice:

MRS C ,C '  1  r

ECO 3152 1-33

The consumer’s optimization determines

• Demand for current consumption C

• Demand for future consumption C’
• Demand for current leisure l
• Demand for future leisure l’
• Labour supply in the current period Ns
• Labour supply in the future period Ns’
• Savings,
S p  w(h l )  T C

ECO 3152 1-34

Demand for current consumption goods

ECO 3152 1-35

Effects of an increase in the real interest rate on
the demand for current consumption (SE>IE)

ECO 3152 1-36

An increase in lifetime wealth increases the
demand for consumption goods

ECO 3152 1-37

Consumer’s current labour supply

• The representative consumer’s current labour supply

Ns is determined by three factors
1. Ns increases when the current real wage w increases
(if the substitution effects are assumed to dominate
income effects)
2. Ns decreases when the lifetime wealth increases
3. Ns increases when the real interest rate r increases

ECO 3152 1-38

The consumer’s current labour supply curve
(SE>IE)

ECO 3152 1-39

Effects of an increase in lifetime wealth on the
current period labour supply

ECO 3152 1-40

The intertemporal substitution of leisure

• The three marginal (trade-off) conditions imply that the

consumer faces a trade-off between how much to work
in two periods:

w 1  r 
MRSl ,l ' 
w'

ECO 3152 1-41

An increase in the real interest rate shifts the
current labour supply curve to the right

ECO 3152 1-42

Key lessons

• A dynamic model with endogenous production allows

us to understand the key determinants and the key
implications of investment.
– The main driver of investment is the real interest rate.
– The investment process allows the whole economy to
effectively reallocate consumption across time.
• The real interest rate influences not only
investment, but also labour supply decisions.
• The intertemporal substitution of labour is critical
for understanding model responses to shocks.
ECO 3152 1-43
Investment and Stock Prices (q. 4, Ch. 11)
• In the baseline model, we assumed that any capital the firm has
remaining at the end of the future period can be sold at a price
of one, in terms of consumption goods.
• Suppose instead that this price is p’K.
• What is the marginal costs of investment?
• What is the marginal benefit of investment?
• What is the new optimal investment rule for the firm?
• The price p’K can be interpreted as the firm’s stock price. What
effects does an increase in p’K have on the firm’s investment
schedule?
• What does this imply about the relationship between
investment expenditures and stock prices?
ECO 3152 1-44