Question

Macroeconomics:

A is the productivity A1=4 and A2=4 and K1=25 .. R=0.25 and d=0.1

Suppose that A1 drops but A2 remains the same. Describe in words how first period

output, first period investment and first period profits are affected by this change.

Answer 1

Let us assume the simple law of motion for capital first, such that

K2=(1-d)K1+I1

where K2 is the capital in period 2, d is the depreciation rate of the capital in period 1, (1-d)K1 is the undepreciated capital from period 1 and I1 is the addition to capital through investment in period 1.

Now, if A1 drops, the output in period 1 drops. This would intuitively lower the investment in period 1 as now the workers would earn less because of reduced output. Since the output goes down, first period profits go down as well, assuming prices in the market remain the same.