Capital Markets II Capital Markets and the Business

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

A Temporary Drop in Productivity • If the productivity decline is short-lived enough, investment decisions are unaffected.

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

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

A Permanent Drop in Productivity • A long lived productivity decline impacts the demand for capital.

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

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

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

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

GDP & Consumption

GDP & Investment

GDP & Gross Savings

GDP & Interest Rates

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?

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.

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.

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.