Effects of...
In general, q is the jumpy variable (just like consumption in RCK) and the variable that slowly adjusts is K (again, just like RCK).
Output Movements:
- Suppose there is a permanent increase in output.
- The market value of firms' assets would increase above 1.
- The \(\dot q = 0\) line to shift out, intersecting the \(\dot k = 0\) line at a higher level of capital.
- Stock prices will boom since investment increased (signaling that it's a good time to get into the industry). Thus a permanent increase in output leads to a temporary increase in stock prices and profit per firm.
- K, total capital in the industry, increases as new firms enter or firms want to grow. Now, profits will slowly fall as the price of capital equilibrates to the increased demand.
- When will the industry stop expanding? When q = 1 again (there are no more unexploited opportunities).
- What if the increase is temporary? q jumps up but will fall back on the stable arm to the original equilibrium
Interest Rate Movements
- Suppose interest rates decline.
- Stock prices will increase to stimulate investment spending
- Since interest appears on the q function, the slope of the line will change as it gets steeper and shifts out.
- Once it falls back on a stable arm, equilibrium will be at a higher level than before.
- If the increase was temporary, then it will jump up but fall back on the original equilibrium again.
*This is where the model has implications for ABCT. If there is a credit-expansion, industry capital will increase though firms know it is only temporary, so they will try to be on the right level for it to come back to equilibrium when the rate decreases again. Thus, there is a cyclical nature to this analysis without hypothesizing malinvestment stupidity.
Tax Credits
- Suppose their is an investment tax credit.
- This decreases the cost of investment and causes the K line to drop.
- Since this is an artificial decrease in price, and the demand for firms' services have not increased, the value of each capital unit is less. Thus the industry capital stock is higher, but the market value has declined.
- When the tax credit is taken away, the industry will shrink and the market will go back to the original values.
*Remember: here, the fundamentals of the market have not changed, and therefore the market was flooded temporarily.