Investment, Capacity Utilization and the Real Business Cycle

Abstract

The present paper adopts the Keynesian view that direct shocks to investment are important for business fluctuations, but incorporates them in a neo-classical framework where the rate of capital utilization is endogenous. In contrast to the intertemporal substitution effect of labor supply, at work in the standard neo-classical models, the transmission mechanism of the investment shocks works here through the optimal capacity utilization decision and the demand side of the labor market. The crucial feature of the model that determines the optimal utilization rate is Keyne's notion of 'user cost'. Given this mechanism labor productivity shifts became endogenous outcomes, rather than given exogenously as in the existing real business cycle models. The interaction between investment shocks and labor demand studied here seems to contribute to the understanding of the co-movements of macroeconomic variables observed during the cycle.