A Real Intertemporal Model with

Investment:
Responses to TFP shocks

CHAPTER 11 - PART III

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 the firm.
• Show how macroeconomic shocks affect the
economy.
• Focus on the implications of future expectations for
current macroeconomic performance.

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Key lessons from the intertemporal model

• Temporary and permanent shocks have different effects

on macroeconomic variables.
• Expectations about future shocks can have important
macroeconomic effects in the current period.

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Experiments using the intertemporal model

• z increases
• z’ increases (news about the future)
• G increases temporarily (stimulus, the multiplier, and
crowding out)
• K decreases (capital destruction or natural disasters)
• An increase in credit market uncertainty

• Note: We can also consider different combinations of

the shocks.

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Model overview
• Two periods: the current and the future
• The representative consumer
– Work/leisure & consumption/savings decisions to maximize
the life-time utility
• The representative firm
– The labour demand, investment and production decisions to
maximize the present value of profits
• Government
– Provides public goods G and G’, collects taxes and issues
bonds. The intertemporal budget constraint of the
government holds.

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The current period competitive equilibrium

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Temporary increase in the current period TFP z

• z increases; other exogenous variables are unchanged

• Approach to analyzing the equilibrium effects:
– Start in the equilibrium
– Given the current prices, determine the direct impact of an
increase in z on the optimal decisions of the consumer and
the firm (partial equilibrium effects)
– Determine the implications for the output supply curve and
the output demand curve
– Identify how the prices should change to restore the
equilibrium
– Determine the joint changes in the prices and quantities in
each market

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Partial equilibrium effects from higher z
• Keeping the real wages w and w’ and the real interest
rate r “fixed,” determine the impact on the labour
supply, the labour demand, the consumption demand
and the investment demand.
• The consumer’s choice:
– The labour supply
– The consumption demand
• The firm’s choice:
– The labour demand
– The investment demand
• The government’s choice: taxes and debt

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WORKSHEET: Partial equilibrium effects on
labour demand curve
• How (if at all) does the
labour demand curve
change in response to an
increase in z?

• Recall:
• MPN = w
• MPN =zF2(K,N)

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WORKSHEET: Partial equilibrium effects on
labour supply curve
• How (if at all) does the labour
supply curve change in
response to an increase in z?
• Recall:
• Ns= h- l
• Intertemporal budget constraint

MRSl ,C  w MRSl ',C '  w'

MRS C ,C '  1  r

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Partial equilibrium effects on the labour market
(the real interest rate r is kept “fixed”)

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WORKSHEET: Partial equilibrium effects on the
goods market – the output supply curve
• How (if at all) does the
ouput supply curve
change in response to an
increase in z?

• Recall
• Y=zF(K,N)

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WORKSHEET: Partial equilibrium effects on the
goods market – the output demand curve
• Keeping the real wages w and w’ and the real interest
rate r “fixed”, we need to determine the impact on the
output demand curve by analyzing the direct impact of
higher z on aggregate demand components
– The consumption demand Cd
– The investment demand Id
– The demand for government goods G

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WORKSHEET: Partial equilibrium effects on the
consumption demand curve
• How (if at all) does the
demand for current
consumption goods curve
change in response to an
increase in z?

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WORKSHEET: Partial equilibrium effects on the
consumption demand curve
• How (if at all) does the
demand for investment
curve change in response
to an increase in z?

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WORKSHEET: Partial equilibrium effects on the
goods market – the output demand curve
• How (if at all) does the
output demand curve
change in response to an
increase in z?

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The response of the goods market

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Partial equilibrium effects from higher z:
summary
• Given w, w’ and r ,
• The consumer’s choice:
– The labour supply is not affected
– The consumption demand is not affected
• The firm’s choice:
– The labour demand curve shifts out, since the marginal
production of labour increases, and the marginal product
of labour is decreasing in labour
– The Investment demand is not affected
• The government’s choice: not affected

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Partial equilibrium effects from higher z
summary - continued
• The output supply curve:
– shifts to the right, due to the increased demand for
labour and higher equilibrium employment
• The output demand curve:
– No direct impact from higher z

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Equilibrium responses of the labour market
(taking into account a fall in r)
• The equilibrium response
combines the direct effects of
changes in z and the impact of
the equilibrium real interest
rate changes.

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Feedback from the real interest rate adjustments

• The goods market:

– The real interest rate falls
• The labour market:
– The decrease in the real interest rate causes intertemporal
substitution of leisure between the current and the future
periods.
– The intertemporal substitution suggests that current leisure is
relatively cheaper in the current period
– Leisure increases, thereby exerting a negative impact on
labour supply. Thus, the labour supply curve shift to the left.

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The equilibrium effects of an increase in the
current period total factor productivity

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The general equilibrium effects

• The equilibrium responses take into account the

change in w and r
• The labour market:
– The real wage increases
– The net effect on the equilibrium quantity of employment
can be viewed as ambiguous
– However, the empirical effects of the real interest rate on
labour supply is relatively small, so employment is predicted
to increase.
• The goods market:
– The real interest rate decreases
– The output increases

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WORKSHEET: Equilibrium effects on
consumption
• The equilibrium response
takes into account the
equilibrium changes in
income and the real
interest rate.

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WORKSHEET: Equilibrium effects on investment

• The equilibrium response

takes into account the
equilibrium changes in
the real interest rate.

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Summary of the equilibrium responses to ↑z

• The labour market:

– Employment is higher, the real wage is higher
• The goods market:
– Output is higher, the real interest is lower
• Implications for consumption and investment:
– Investment is higher, as it is a negative function of the real
interest rate
– Consumption is higher, due to the lower real interest rate and
higher income

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