Economic Research and Perspectives

Economic Research and Perspectives

Marginal Efficiency of Investment Shocks and Consumption Puzzle A Dynamic Stochastic General Equilibrium Model

Authors
Mousa Maghsoudi 1
Mansour Zarra-Nezhad 2
Masoud Khodapanah 3
1 Ph.D student in Economics, Faculty of Economics and Social Sciences, Shahid Chamran University of Ahvaz, Ahvaz, Iran
2 Professor, Department of Economics, Faculty of Economics and Social Sciences, Shahid Chamran University of Ahvaz, Ahvaz, Iran
3 Associate Professor, Department of Economics, Faculty of Economics and Social Sciences, Shahid Chamran University of Ahvaz, Ahvaz, Iran
10.22034/25.1.267
Abstract
Aim and Introduction

Studies and contributions of structural vector autoexplanatory models using Bayesian and classical techniques have provided evidence that shocks to the marginal efficiency of investment are the main drivers of economic volatility in US postwar data. However, dynamic stochastic general equilibrium models attempt to explain the movement of consumption with production following a marginal efficiency of investment (MEI) shock. Indeed, the decline in consumption after a positive MEI shock contradicts empirically identified business cycles. This issue is referred to as the consumption puzzle. In other words, consumption usually decreases after a positive investment shock in the model. Therefore, the usual DSGE models do not produce the observed co-movement between macroeconomic variables in response to the marginal efficiency of investment shock. From an empirical perspective, consumption, investment, working hours and production all move together. This lack of coordination of consumption in response to investment shocks is problematic as an important source of business cycles.

A review of empirical studies indicates that investment shocks and consumption puzzle have received limited attention. In this regard, the main aim and innovation of the current study is to set up a dynamic stochastic general equilibrium (DSGE) model and use the Bayesian approach for Iran in order to bridge this study gap as much as possible.

The marginal efficiency of investment shock is a source of exogenous changes in the efficiency with which the final good can be converted into physical capital and thus into future capital input. This change may be due to technological factors specific to the production of investment goods. On the other hand, exogenous changes in efficiency can result from disturbances in the process of converting these investment goods into productive capital.

In neoclassical models, after a positive MEI shock, households trading in

financial markets increase their investment and reduce consumption. In fact, an intertemporal substitution effect occurs between the current consumption and investment, which creates a negative wealth effect and, therefore, creates the so-called consumption puzzle. The mechanism behind the puzzle was first described by Barrow and King (1984). The idea is that if an efficient equilibrium exists, the marginal rate of substitution between consumption and leisure should equal the marginal product of labor. This condition implies that with exogenous shocks that only indirectly affect marginal production labor, as MEI shocks actually do, consumption and labor hours move in opposite directions. Therefore, although MEI shocks account for up to 60% of the variance in output and working hours, the argument that investment shocks are one of the most important drivers of macroeconomic fluctuations is challenging.

Methodology

The core of current research model is derived from the studies of Rohe (2012) and by expanding it, the marginal efficiency of investment shock and the consumption puzzle have been modeled for Iran.

To estimate the model parameters, the Bayesian method, and the Random Walk Metropolis-Hastings algorithm were used. The data of the model’s observable variables include seasonal adjusted data, gross domestic production, private consumption, private investment, government expenditure, and inflation rate (gross) from 2004 to 2022, which underwent a de-trending procedure using the Hodrick-Prescott filter.

Findings

The marginal efficiency of investment shock leads to an increase in the rate of return on capital and investment. Consumption behavior is similar to investment behavior but with less volatility. Due to the increase in the demand side of the economy, inflation will increase and the real exchange rate will decrease. In response to the increase in the demand side, production, wage rates and employment increase. It should be noted that the contractionary monetary policy has led to a reduction in the fluctuations of macroeconomic variables, yet the dynamic of the variables has not changed.

Discussion and Conclusion

In justifying these results, the average mark-up equation of the economy can be used:

Mup,t=MPNtWtPt

where, Mup,t is the average mark-up, MPNt is the marginal product of labor, Wt is the nominal wage rate and Pt is the price index in period t.

The equilibrium conditions of the labor market can also be introduced as follows:

1Mup,tMPNtNt=MRStCt , Nt

Despite nominal price stickiness, firms are not able to increase their prices in response to the increase in demand caused by the investment boom resulted from shocks. Therefore, the average mark-up of the economy decreases and effectively shifts the labor demand curve upwards. In this situation, consumption and working hours increase. In other words, in spite of inseparable preferences and in the conditions that the increase of working hours has a positive effect on the marginal utility of consumption (the complementarity of working hours and consumption), the co-movement of investment, production, working hours and consumption can be justified and the puzzle of consumption does not occur

Keywords
Marginal Efficiency of Investment
Consumption Puzzle
Monetary policy
Bayesian Estimation

Subjects

Akbari, M., & Sharifzade, M. J. (2017). Determining the Optimal Monetary Policy Rule with Respect to Home Bias in Consumption: Application of Bayesian Approach. Journal of Economics and Modelling, 8(29), 1-39. (In Persian).
https://ecoj.sbu.ac.ir/article49613-9d5305b2aa70ee9896e26d0b66ba2b1f.pdf
Barro, R. J., & King, R. G. (1984). Time-Separable Preferences and Intertemporal-Substitution Models of Business Cycles. The Quarterly Journal of Economics, 99(4), 817-839. https://doi.org/10.2307/1883127
Basu, S., & Kimball, M. (2002). Long-Run Labor Supply and the Elasticity of Intertemporal Substitution for Consumption.
Brooks, S. P., & Gelman, A. (1998). General Methods for Monitoring Convergence of Iterative Simulations. Journal of Computational and Graphical Statistics, 7(4), 434-455. https://doi.org/10.1080/10618600.1998.10474787
Chirichiello, G. (2024). DSGE Models for Real Business Cycle and New Keynesian Macroeconomics. Springer Cham.
Chiarini, B., Ferrara, M., & Marzano, E. (2020). Tax Evasion, Investment Shocks, and the Consumption Puzzle: A DSGE Analysis with Financial Frictions. Journal of Money, Credit and Banking, 52(4), 907-932. https://doi.org/10.1111/jmcb.12616
Choi, Y. (2020). INVESTMENT SHOCKS, CONSUMPTION PUZZLE, AND BUSINESS CYCLES. Economic Inquiry, 58(3), 1387-1400. https://doi.org/10.1111/ecin.12856
Dib, A. (2001). An Estimated Canadian DSGE Model with Nominal and Real Rigidities. Bank of Canada working paper1701-93972001-26. https://doi.org/10.34989/swp-2001-26
Furlanetto, F., & Seneca, M. (2014). Investment shocks and consumption. European Economic Review, 66(C), 111-126. https://EconPapers.repec.org/RePEc:eee:eecrev:v:66:y:2014:i:c:p:111-126
Gertler, M., Sala, L., & Trigari, A. (2008). An Estimated Monetary DSGE Model with Unemployment and Staggered Nominal Wage Bargaining. Journal of Money, Credit and Banking, 40(8), 1713-1764. http://www.jstor.org/stable/25483468
Greenwood, J., Hercowitz, Z., & Huffman, G. W. (1988). Investment, Capacity Utilization, and the Real Business Cycle. The American Economic Review, 78(3), 402-417. http://www.jstor.org/stable/1809141
Guerron-Quintana, P. (2008). Refinements on macroeconomic modeling: The role of non-separability and heterogeneous labor supply. Journal of Economic Dynamics and Control, 32(11), 3613-3630. https://EconPapers.repec.org/RePEc:eee:dyncon:v:32:y:2008:i:11:p:3613-3630
Hosseini, N. S., & Asgharpur, H. (2021). Exchange Rate Pass-Through and the Effects of Monetary Shock in a DSGE Model. Economic Growth and Development Research, 11(42), 154-131. (In Persian). https://doi.org/10.30473/egdr.2019.48777.5416
Hou, Z., Song, Y., & Xin, W. (2022). COVID-19 Shocks, Monetary Policy, and Real Estate Price Volatility: Analysis Based on a Dynamic Stochastic General Equilibrium Perspective. Scientific Programming, 2022, 7625465. https://doi.org/10.1155/2022/7625465
Justiniano, A., Primiceri, G. E., & Tambalotti, A. (2010). Investment shocks and business cycles. Journal of Monetary Economics, 57(2), 132-145. https://doi.org/10.1016/j.jmoneco.2009.12.008
Justiniano, A., Primiceri, G. E., & Tambalotti, A. (2011). Investment shocks and the relative price of investment. Review of Economic Dynamics, 14(1), 102-121. https://doi.org/10.1016/j.red.2010.08.004
Keshavarzi, A., Horry, H. R., & Mahmoodi, S. (2023). Investigation of the Effects of Public Health Expenditure on Macroeconomic Variables under Conditions of Pandemic Disease Outbreak: an Application of the New Keynesian Model. The Economic Research (Sustainable Growth and Development), 23(4), 153-182. (In Persian) http://ecor.modares.ac.ir/article-18-64833-fa.html
Khan, H., & Tsoukalas, J. (2011). Investment shocks and the comovement problem. Journal of Economic Dynamics and Control, 35(1), 115-130. https://doi.org/10.1016/j.jedc.2010.09.004
Kilponen, J. (2012). Consumption, Leisure and Borrowing Constraints. The B.E. Journal of Macroeconomics, 12(1). https://doi.org/10.1515/1935-1690.2061
Kilponen, J., Vilmunen, J., & Vähämaa, O. (2013). Estimating intertemporal elasticity of substitution in a sticky price model. https://EconPapers.repec.org/RePEc:zbw:bofrdp:rdp2013_009
Kim, K. H., & Katayama, M. (2013). Non-separability and sectoral comovement in a sticky price model. Journal of Economic Dynamics and Control, 37(9), 1715-1735. https://doi.org/10.1016/j.jedc.2013.04.012
King, R. G., & Rebelo, S. T. (1999). Chapter 14 Resuscitating real business cycles. In Handbook of Macroeconomics (Vol. 1, pp. 927-1007). Elsevier. https://doi.org/10.1016/S1574-0048(99)10022-3
Kydland, F. E., & Prescott, E. C. (1982). Time to Build and Aggregate Fluctuations. Econometrica, 50(6), 1345-1370. https://doi.org/10.2307/1913386
Pasha zanous, p., Bahrami, J., Tavakkolian, H., & Mohammadi, T. (2019). Investigating the performance of currency regimes in production and inflation fluctuations under international financial integration conditions for Iran: using a DSGE Model. new economy and trad, 14(3), 41-69. (In Persian). https://jnet.ihcs.ac.ir/article_4990_8675c383d6212a6c03c95a803e7c1322.pdf
Rafei, M., Bahrami, J., & Daneshjafari, D. (2014). Evaluation of Fiscal Policy for Economy of Iran in a Dynamic Stochastic General Equilibrium Model based on Real Business Cycles. Economics Research, 14(54), 33-65. (In Persian). https://joer.atu.ac.ir/article797e756de89d52786b4b246687f453e551f.pdf
Rahmani, A., Samadi, S., & Bakhshi Dastjerdi, R. (2021). Investigating the Effect of Financial and Monetary Policy on the Iranian Stock Market by Using DSGE Model. Iranian Economic Review, 25(3), 509-523. https://doi.org/10.22059/ier.2021.84146
Reza, A. (2014). Consumption response to investment shocks under financial frictions. Economics Letters, 123(1), 50-53. https://doi.org/10.1016/j.econlet.2014.01.009
Röhe, O. (2012). New Keynesian DSGE models: theory, empirical implementation, and specification. https://api.semanticscholar.org/CorpusID:150433440
Rotemberg, J. J. (1982). Monopolistic Price Adjustment and Aggregate Output. The Review of Economic Studies, 49(4), 517-531. https://doi.org/10.2307/2297284
Schmitt-Grohé, S., & Uribe, M. (2012). WHAT'S NEWS IN BUSINESS CYCLES. Econometrica, 80(6), 2733-2764. http://www.jstor.org/stable/23357239
Sims, C. A. (1980). Macroeconomics and Reality. Econometrica, 48(1), 1-48. https://doi.org/10.2307/1912017
Tavakolian, H. (2021). Dynamic Stochastic General Equilibrium Models in Iran: Deterministic or Stochastic Steady State? Journal of Economic Research (Tahghighat- E- Eghtesadi), 55(4), 781-812. (In Persian). https://doi.org/10.22059/jte.2021.317990.1008424