Thread by @BachmannRudi

Lecture 8 Intermediate Macro:

Today we finished the consumption part of the lecture with a second microfoundation for kinked budget sets: collateral constraints. Collateralized loans are an institutional feature to overcome the fact that people in general cannot commit to repay

loans no matter what (think of the merchant Antonio in the Merchant of Venice). So, lenders will often demand collateral with a loan. The most important instance in practice are mortgages, where the house serves as the underlying collateral

(an example of uncollateralized loans are credit cards). As a consequence, agents can only borrow against future house values but not against future endowment (or labor) income. This also leads to kinked budget sets.

Perhaps more importantly, when house prices decline, they are detrimental for TWO reasons: (1) they destroy wealth, the way a stock market decline would. This is bad and consumption and welfare will decline as well.

(2) they limit further the ability to borrow and thus to smooth consumption for the households (an effect that a stock market decline would not have to such a degree). In fact, a house price decline for a constrained household will fully go into the reduction of today's

consumption, not into any reduction of future consumption. This explains why recession after housing crises tend to be worse than after stock market crises.

Then we changed gears. Recall for the closed economy: Y=C+I+G or S=I. We have so far talked about C and S and a bit about G. Next, we need a theory of investment I before we can bring both theories together as a theory of aggregate demand. The theory of investment is a (simple)

theory of the firm. A firm is a production function (the mathematical representation of the idea of an entrepreneur), it lives two periods, today and tomorrow. The entrepreneur uses own funds or borrows (in the baseline model it does not matter) to finance her activity.

She maximizes her lifetime wealth from the firm by choosing the optimal labor input today and tomorrow and the optimal investment level, that is, given the current capital stock, tomorrow's capital stock.

We saw that in the simple model, labor demand was a static/intratemporal decision, we did not need to study both periods (that is a simplification, there are more elaborate dynamic labor demand models, when you do a PhD).

We derived a simple optimality condition: marginal product of labor equals the real wage.

Next, we studied the intertemporal decision of investment, which boils down to a simple arbitrage condition: r=future net marginal product of capital (in more complicated models with a price of capital that is not the same as the output price, one would also have to take into

account expected changes in the price of capital, but not here).

It means: the direct or opportunity costs of funds in the credit market need to be equal the net marginal product of capital. In other words, an entrepreneur has to be at the margin indifferent between funds in her firm and in the financial markets.

This calculation, in turn, leads to a downward sloping investment demand curve (in r) that shifts to the right with an increase in future TFP (news-driven or animal spirits-driven investment cycles) or a destruction of today's capital stock (natural disaster or war).

Before we combine investment and consumption theory into aggregate demand theory, we study two applications of the investment model:

(1) if we add also asymmetric information to this world, we see that financial distress in the form of higher credit spreads (on Wallstreet) will effect real physical investment (on Mainstreet).

(2) We will apply this model to residential construction and learn how expected house price booms will lead to residential construction booms.

End Thread.