1. Capital Markets:II Capital Markets and the Business Cycle

2. Analysis of Capital Markets Aggregate Savings Aggregate Investment

3. 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

4. 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

5. 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.

6. 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.

7. 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.

8. A Temporary Drop in Productivity

9. If the productivity decline is short-lived enough, investment decisions are unaffected.

10. 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

11. 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

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

13. 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

14. 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

15. 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)

16. 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:

17. 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

18. Interest Rates: 1972-1980

19. Business Cycle Characteristics Can our model of capital markets replicate the relevant business cycle facts?

20. Business Cycle Characteristics Can our model of capital markets replicate the relevant business cycle facts? Correlation Volatility Timing

21. GDP

22. GDP & Consumption

23. GDP & Investment

24. GDP & Gross Savings

25. GDP & Interest Rates

26. Capital Market Facts VariableDirectionTiming ConsumptionProcyclicalCoincident InvestmentProcyclicalCoincident/Leading Savings??? Interest RatesProcyclicalLagging

27. Can our capital market model explain these facts?

28. As with labor markets, the key is the price/output correlation. Specifically, remember that the interest rate is procyclical.

29. 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.

30. 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.