Scandinavian Working Papers in Economics

SSE/EFI Working Paper Series in Economics and Finance,
Stockholm School of Economics

No 643: Vintage Capital and Expectations Driven Business Cycles

Martin Floden ()
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Martin Floden: Dept. of Economics, Stockholm School of Economics, Postal: Stockholm School of Economics, P.O. Box 6501, SE-113 83 Stockholm, Sweden

Abstract: This paper demonstrates that increased optimism about future productivity can generate an immediate economic expansion in a neoclassical model with vintage capital and variable capacity utilization. Previous research has documented that standard neoclassical models cannot generate a simultaneous increase in consumption, investment, and hours in response to news shocks, and that optimism in these models tends to reduce investment and hours. When technology is vintage specific, however, expectations of higher future productivity raise the demand for new vintages of capital relative to old capital. Capital depreciates faster when utilization is high, but this depreciation only affects installed capital. The cost of high depreciation therefore falls when the value of installed capital falls. It is demonstrated here that with standard parameter values, more optimism raises utilization, consumption, investment, hours, and output.

Keywords: Expectations; News; Business cycles; Vintage capital; Capital-embodied technological change

JEL-codes: E13; E32

22 pages, November 10, 2006

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