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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• 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• Firms take technology,
employment, and interest rates as given and choose capital to maximize firm value.
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• 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• 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)
Aggregate Investment• 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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0 100 200 300 400 500
A Temporary Drop in Productivity
• If the productivity decline is short-lived enough, investment decisions are unaffected.
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0 100 200 300 400 500
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
0
4
8
12
16
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0 100 200 300 400 500
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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8
12
16
20
0 100 200 300 400 500
A Permanent Drop in Productivity
• A long lived productivity decline impacts the demand for capital.
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0 100 200 300 400 500
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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8
12
16
20
0 100 200 300 400 500
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
0
4
8
12
16
20
0 100 200 300 400 500
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
Interest Rates: 1972-1980
0
2
4
6
8
10
12
14
16
J-72
J-72
J-73
J-73
J-74
J-74
J-75
J-75
J-76
J-76
J-77
J-77
J-78
J-78
J-79
J-79
J-80
J-80
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
GDP
-6
-4
-2
0
2
4
6
1/1/82
1/1/84
1/1/86
1/1/88
1/1/90
1/1/92
1/1/94
1/1/96
1/1/98
1/1/00
GDP
GDP & Consumption
-6
-4
-2
0
2
4
6
1/1/82
1/1/84
1/1/86
1/1/88
1/1/90
1/1/92
1/1/94
1/1/96
1/1/98
1/1/00
GDPConsumption
GDP & Investment
-25
-20
-15
-10
-5
0
5
10
15
20
25
1/1/82
1/1/84
1/1/86
1/1/88
1/1/90
1/1/92
1/1/94
1/1/96
1/1/98
1/1/00
GDPInvestment
GDP & Gross Savings1/1/82
1/1/84
1/1/86
1/1/88
1/1/90
1/1/92
1/1/94
1/1/96
1/1/98
1/1/00
GDPSaving
GDP & Interest Rates
-5
-4
-3
-2
-1
0
1
2
3
4
5
1/1/82
1/1/84
1/1/86
1/1/88
1/1/90
1/1/92
1/1/94
1/1/96
1/1/98
1/1/00
0
2
4
6
8
10
12
14
GDPInterest
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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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.
0
4
8
12
16
20
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.
0
4
8
12
16
20
24
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.
0
4
8
12
16
20
24
0 100 200 300 400 500
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