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

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Capital markets ii

Capital Markets:II

Capital Markets and the Business Cycle


Analysis of capital markets

Aggregate Savings

Aggregate Investment

Analysis of Capital Markets


Analysis of capital markets1

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


Analysis of capital markets2

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


Analysis of capital markets3

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


Analysis of capital markets4

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


Analysis of capital markets5

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.

Analysis of Capital Markets



A temporary drop in productivity1
A Temporary Drop in Productivity

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


A temporary drop in productivity2
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 productivity3
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 Permanent Drop in Productivity

  • A long lived productivity decline impacts the demand for capital.


A permanent drop in productivity1
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 productivity2
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
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 shocks1
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 shocks2
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



Business cycle characteristics
Business Cycle Characteristics

  • Can our model of capital markets replicate the relevant business cycle facts?


Business cycle characteristics1
Business Cycle Characteristics

  • Can our model of capital markets replicate the relevant business cycle facts?

    • Correlation

    • Volatility

    • Timing









Can our capital market model explain these facts1
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 facts2
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 facts3
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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