Productivity Shocks, Investment, and the Real Interest Rate

Working Paper 99-2
by Giovanni Olivei
1999 Series

I analyze the effects of a favorable shift in expected future productivity on the current level of investment and the real interest rate. In a standard RBC model, an increase in expected future productivity raises the real rate, but decreases the current level of investment for plausible parameter values of the intertemporal elasticity of substitution in consumption. However, it is shown that such a conclusion is unwarranted when nominal rigidities are introduced into the analysis. In contrast with the flexible-price case, the favorable shift in future productivity can lead to an increase in current investment, while at the same time driving up significantly the real rate of interest. The model with nominal rigidities lends theoretical support to the view expressed by some authors (e.g., Blanchard and Summers (1984), and Barro and Sala-i-Martin (1990)), that the surge in investment and the real rate across industrialized countries in 1983-84 was caused by a favorable shift in expected future profitability.

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