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Investment options and the business cycle

  • Jovanovic, Boyan

This paper extends [R. Mehra, E.C. Prescott, Recursive competitive equilibrium: The case of homogeneous households, Econometrica 48 (1980) 1365-1380] to a production economy with two capital goods. It is an RBC model in which each unit of investment requires a new idea, an 'option.' When options are scarce, new capital is harder to put in place and the value of old capital rises. Thus the stock market and Tobin's Q are negative indexes of intangibles. During a boom, Q rises gradually, as options are used up. Because investment represents an exercise of options, it has an intertemporal substitution tradeoff that is absent from the adjustment-cost model. Equilibrium may be efficient even without markets for knowledge; the stock market may suffice.

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Article provided by Elsevier in its journal Journal of Economic Theory.

Volume (Year): 144 (2009)
Issue (Month): 6 (November)
Pages: 2247-2265

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Handle: RePEc:eee:jetheo:v:144:y:2009:i:6:p:2247-2265
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