Question

Suppose there is a RISE in the real price of capital (p_k).  Notice that capital has become relatively more costly.

a. [2 points] Use a diagram to Illustrate the the impact of a RISE in the real price of capitalon optimal Kf* (i.e. optimal future capital stock).   Label everything in your diagram.

b. [1 points] Continue with a. Is the shock causing MPKf>user costs orMPKf<user costs?  Just state.  Will the firm increase profits by increasing Kf* or decreasing Kf*?  Just state. No discussion.

c. [3 points] Given your results above, what impact does the shock have on the S-I model? Specifically, illustrate the impact on the S-I diagram. Label everything in your diagram.

d. [3 points] Continue with c. Now discuss the impact on equilibrium r, S, and I (as done in lecture).   In your discussion, elaborate on which curve you shift and why, and what leads to the change in r, S, and I. Make sure to provide COMPLETE economic reasoning/intuition of the mechanism that transmits the shock; i.e. elaborate on your answer.

e. [1 points] Now state the final impact on C and Y once the Output Market adjusts and the new equilibrium is reached. Just state (increase or decrease). No discussion.

Answer 1

B)

User cost of capital (uc) does not vary with capital so it is a horizontal line. If MPKf > uc then the marginal benefit > marginal cost ( profits rise as K rises). If MPKf < uc then the marginal benefit < marginal cost ( profts rise as K falls). Thus, profits are maximised when MPKf = uc.

D)

Rise in price of real capital ( r1 to r2) => a shift of S=I from point A to B in the horizontal axis. E1 shifts to E2 with the savings function shifting to its left. Thus, investment also reduces to B. Hence we can say that both investment and capital reduces in the economy. A decrease in savings will crowd out investment as real price of capital increases.

E) Savings shift left, fall in current output.