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Lecture 14: Capital Utilisation and the Business Cycle L11200 Introduction to Macroeconomics 2009/10 Reading: Barro Ch.9 24 February 2010
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Introduction Last time: – Developed model to incorporate labour supply decisions on part of the household – Predictions for procyclicality of employment and hours matched the data Today – Model cannot explain non-employment of factors of production: today consider capital
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The Problem, Again ‘Equilibrium Business Cycle model’ – Based on idea that capital and labour markets are continually in equilibrium – Excess demand (shortages) or excess supply (unemployment) cannot occur – But unemployment of both labour and capital occur over the business cycle
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K in the model So far, K has represented both the stock and flow of capital – i.e. K units of capital held by firms were always used in the production – Now change this: firms could hold a stock of capital but choose not to use it – (just like households having a ‘stock’ of labour time available but choosing not to work)
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Modifying K Replace K in the production function with some proportional κK – κ is the ‘utilisation rate’: the proportion of capital held by households which they actually use – This is very similar to allowing L to vary and become L s instead
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Demand for Capital Services So now compute how much of the stock of capital K is demanded: ‘capital services’ – Previously calculated demand for capital as a function of real rental cost R/P – If A increased, MPK increased so demand for capital shifted outwards – The same is true for some fixed utilisation rate κ
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Supply of Capital Services This is the element which now alters: households do not necessarily sell all of their capital to the capital market – Firms might not want to sell all capital if depreciation rate depends on intensity use – i.e. using machines more intensely raises depreciations
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Supply Decision So now net real income from supplying capital services given by: Rate of return from owning capital is:
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Supply Decision So rental income is increasing in intensity, but so is depreciation rate – Rate of return is a linear function of κ, i.e. using machines more intensely matches 1:1 to higher rental income – Depreciation is a non-linear function of κ, i.e. more intensive use increases depreciation rate
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Optimal Capital Supply So optimal supply point maximises net capital rental income – i.e. maximum distance between the two curves – Can analyse impact of changing variables – Most importantly: if R/P increases, encourages more supply of capital – So have a upward-sloping relationship between R/P and capital supply
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Implication So should find that capital utilisation rate is procyclical – When economy faces positive technology shock, demand for capital services increases – Supply response raises rental rate (and so raises i) and increases capital supply – So capital utilisation and interest rate both move with growth in output
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Labour Supply With capital, we found that variable capital supply resulted in procyclical utilisation as well as procyclical price for capital – Same pattern as we found for labour supply – Bigger challenge in modelling labour supply is to explain unemployment – Need to introduce some friction in the model which prevents immediate adjustment to new equilibrium
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Employment over the Business Cycle From lecture 2, we need some basic distinctions – Labour force: everyone who wants to work – Employed: people who want to work and have a job – Unemployed: people who want to work and don’t have a job – Key: variations in employment over the business cycle are not explained by variation in labour force
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Implications Missing element must be unemployment – Not the case that fluctuations in employment are due to people wanting work more when economy is booming / less when economy is contracting – Instead, when economy is contracting people still want work but cannot find it – This is unemployment: how do we explain it?
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Summary Capital utilisation varies over the business cycle – Built a model of capital supply based on depreciation being a function of capital intensity – Generated upward-sloping supply and matched the aggregate data Next time: unemployment, the missing element in the model
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