Adjustment Costs and Aggregate Demand Theory

Abstract

approach to be consistent with present value maximization, a production function homogeneous of degree one in labour, capital and investment (such as that assumed by Lucas, 1967) is required. However, if the relationship between the capital stock and the market value of the firm is ignored and investment is related directly to the gap between capital's marginal product and its rental cost (which requires the assumption of static expectations), then a non-homogeneous production function (such as that assumed by Gould, 1968) is permissible. In Section II we outline the changes in the standard macroeconomic model that are required for it to be consistent with the existence of adjustment costs. This involves changing the definitions of goods market clearing and disposable income, since, with adjustment costs, some output is wasted but its production creates income that is usually ignored. We demonstrate that, by not properly noting these points, macroeconomic policy analysis has typically involved an over-simplified expression for the interest elasticity of aggregate demand. In view of the fact that the price sensitivity of aggregate demand depends directly on this interest elasticity, and that the case for rules over a discretionary stabilization policy in turn depends on the strength of this price sensitivity, this point is potentially very important. In Section III we illustrate the possible significance of this analytically consistent approach by referring to existing parameter estimates. Readers who are solely interested in the macroeconomic implications of alternative specifications of adjustment costs may proceed directly to Section II.