Transcript Capital Markets:II

Capital Markets:II
Capital Markets and the Business
Cycle
Analysis of Capital Markets
Aggregate Savings
Aggregate Investment
Analysis of Capital Markets
Aggregate Savings
• Households take wealth and
interest rates as given and
maximize utility through their
choice of consumption
(Savings = Income – Cons.)
Aggregate Investment
Analysis of Capital Markets
Aggregate Savings
• Households take wealth and
interest rates as given and
maximize utility through their
choice of consumption
(Savings = Income – Cons.)
• Rising (falling) interest rates
induce a dominant substitution
effect which causes current
consumption to fall (rise) – that
is, savings rises (falls).
Aggregate Investment
Analysis of Capital Markets
Aggregate Savings
Aggregate Investment
• Households take wealth and
interest rates as given and
maximize utility through their
choice of consumption
(Savings = Income – Cons.)
• Rising (falling) interest rates
induce a dominant substitution
effect which causes current
consumption to fall (rise) – that
is, savings rises (falls).
• Firms take technology,
employment, and interest rates
as given and choose capital to
maximize firm value.
Analysis of Capital Markets
Aggregate Savings
Aggregate Investment
• Households take wealth and
interest rates as given and
maximize utility through their
choice of consumption
(Savings = Income – Cons.)
• Rising (falling) interest rates
induce a dominant substitution
effect which causes current
consumption to fall (rise) – that
is, savings rises (falls).
• Firms take technology,
employment, and interest rates
as given and choose capital to
maximize firm value.
• Decreasing MPK insures that
rising interest rates will lower
demand for capital.
Analysis of Capital Markets
Aggregate Savings
Aggregate Investment
• Savings is used to smooth
consumption in the face of
variable income.
Therefore, a perceived rise
(fall) in income will cause
savings to decrease
(increase)
• An increase (decrease) in
productivity increases
(decreases) investment
demand, but the lag
between purchase and
installation of capital must
be considered.
A Temporary Drop in
Productivity
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A Temporary Drop in
Productivity
• If the productivity decline
is short-lived enough,
investment decisions are
unaffected.
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A Temporary Drop in
Productivity
• If the productivity decline
is short-lived enough,
investment decisions are
unaffected.
• However, the temporary
decline in income lowers
aggregate savings
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A Temporary Drop in
Productivity
• If the productivity decline
is short-lived enough,
investment decisions are
unaffected.
• However, the temporary
decline in income lowers
aggregate savings
• Interest rates rise while
savings and investment
fall
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A Permanent Drop in
Productivity
• A long lived productivity
decline impacts the
demand for capital.
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A Permanent Drop in
Productivity
• A long lived productivity
decline impacts the
demand for capital.
• Income is now
permanently lower –
savings stays the same,
but consumption drops
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A Permanent Drop in
Productivity
• A long lived productivity
decline impacts the
demand for capital.
• Income is now
permanently lower –
savings stays the same,
but consumption drops
• Interest rates, investment,
savings, and consumption
all decline
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Example: Oil Price Shocks
• A rise in energy prices is considered to be a drop
in productivity (think of MPL and MPK as net of
energy costs)
Example: Oil Price Shocks
• A rise in energy prices is considered to be a drop
in productivity (think of MPL and MPK as net of
energy costs)
• The 1970’s saw two major oil price increases:
Example: Oil Price Shocks
• A rise in energy prices is considered to be a drop
in productivity (think of MPL and MPK as net of
energy costs)
• The 1970’s saw two major oil price increases:
– 73-’74: OPEC oil embargo raises oil prices from $4 to
$10 a barrel
– -’78-’79: Iranian Revolution temporarily disrupts oil
production: oil prices rise from $15 to $30 a barrel.
• The first shock was perceived as permanent while
the second was perceived as temporary
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Interest Rates: 1972-1980
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Business Cycle Characteristics
• Can our model of capital markets replicate
the relevant business cycle facts?
Business Cycle Characteristics
• Can our model of capital markets replicate
the relevant business cycle facts?
• Correlation
• Volatility
• Timing
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-4
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1/1/00
1/1/98
1/1/96
1/1/94
1/1/92
1/1/90
1/1/88
1/1/86
1/1/84
1/1/82
GDP
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GDP
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-4
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1/1/00
1/1/98
1/1/96
1/1/94
1/1/92
1/1/90
1/1/88
1/1/86
1/1/84
1/1/82
GDP & Consumption
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4
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GDP
Consumption
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-20
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1/1/00
1/1/98
1/1/96
1/1/94
1/1/92
1/1/90
1/1/88
1/1/86
1/1/84
1/1/82
GDP & Investment
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GDP
Investment
1/1/00
1/1/98
1/1/96
1/1/94
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1/1/90
1/1/88
1/1/86
1/1/84
1/1/82
GDP & Gross Savings
GDP
Saving
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1/1/00
1/1/98
1/1/96
1/1/94
1/1/92
1/1/90
1/1/88
1/1/86
1/1/84
1/1/82
GDP & Interest Rates
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GDP
Interest
Capital Market Facts
Variable
Direction
Timing
Consumption
Procyclical
Coincident
Investment
Procyclical
Coincident/Leading
Savings
???
???
Interest Rates
Procyclical
Lagging
Can our capital market model explain these
facts?
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Can our capital market model explain these
facts?
• As with labor markets, the key
is the price/output correlation.
Specifically, remember that the
interest rate is procyclical.
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12
8
4
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0
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200
300
400
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Can our capital market model explain these
facts?
• As with labor markets, the key
is the price/output correlation.
Specifically, remember that the
interest rate is procyclical.
• This suggests that supply side
factors (ie, productivity) are
behind changes in investment,
savings, and interest rates.
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20
16
12
8
4
0
0
100
200
300
400
500
Can our capital market model explain these
facts?
• As with labor markets, the key
is the price/output correlation.
Specifically, remember that the
interest rate is procyclical.
• This suggests that supply side
factors (ie, productivity) are
behind changes in investment,
savings, and interest rates.
• Further, because investment
drives the results, most shocks
must be perceived as
permanent.
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