Marginal Efficiency of Investment Shocks and Consumption Puzzle A Dynamic Stochastic General Equilibrium Model

Aim and Introduction Studies and contributions of structural vector autoexplanatory models using Bayesian and classical techniques have provided evidence that shocks to the marginal efficiency of investment are the main drivers of economic volatility in US postwar data. However, dynamic stochastic general equilibrium models attempt to explain the movement of consumption with production following a marginal efficiency of investment (MEI) shock. Indeed, the decline in consumption after a positive MEI shock contradicts empirically identified business cycles. This issue is referred to as the consumption puzzle. In other words, consumption usually decreases after a positive investment shock in the model. Therefore, the usual DSGE models do not produce the observed co-movement between macroeconomic variables in response to the marginal efficiency of investment shock. From an empirical perspective, consumption, investment, working hours and production all move together. This lack of coordination of consumption in response to investment shocks is problematic as an important source of business cycles. A review of empirical studies indicates that investment shocks and consumption puzzle have received limited attention. In this regard, the main aim and innovation of the current study is to set up a dynamic stochastic general equilibrium (DSGE) model and use the Bayesian approach for Iran in order to bridge this study gap as much as possible. The marginal efficiency of investment shock is a source of exogenous changes in the efficiency with which the final good can be converted into physical capital and thus into future capital input. This change may be due to technological factors specific to the production of investment goods. On the other hand, exogenous changes in efficiency can result from disturbances in the process of converting these investment goods into productive capital. In neoclassical models, after a positive MEI shock, households trading in financial markets increase their investment and reduce consumption. In fact, an intertemporal substitution effect occurs between the current consumption and investment, which creates a negative wealth effect and, therefore, creates the so-called consumption puzzle. The mechanism behind the puzzle was first described by Barrow and King (1984). The idea is that if an efficient equilibrium exists, the marginal rate of substitution between consumption and leisure should equal the marginal product of labor. This condition implies that with exogenous shocks that only indirectly affect marginal production labor, as MEI shocks actually do, consumption and labor hours move in opposite directions. Therefore, although MEI shocks account for up to 60% of the variance in output and working hours, the argument that investment shocks are one of the most important drivers of macroeconomic fluctuations is challenging. Methodology The core of current research model is derived from the studies of Rohe (2012) and by expanding it, the marginal efficiency of investment shock and the consumption puzzle have been modeled for Iran. To estimate the model parameters, the Bayesian method, and the Random Walk Metropolis-Hastings algorithm were used. The data of the model’s observable variables include seasonal adjusted data, gross domestic production, private consumption, private investment, government expenditure, and inflation rate (gross) from 2004 to 2022, which underwent a de-trending procedure using the Hodrick-Prescott filter. Findings The marginal efficiency of investment shock leads to an increase in the rate of return on capital and investment. Consumption behavior is similar to investment behavior but with less volatility. Due to the increase in the demand side of the economy, inflation will increase and the real exchange rate will decrease. In response to the increase in the demand side, production, wage rates and employment increase. It should be noted that the contractionary monetary policy has led to a reduction in the fluctuations of macroeconomic variables, yet the dynamic of the variables has not changed. Discussion and Conclusion In justifying these results, the average mark-up equation of the economy can be used: Mup,t=MPNtWtPt where, Mup,t is the average mark-up, MPNt is the marginal product of labor, Wt is the nominal wage rate and Pt is the price index in period t. The equilibrium conditions of the labor market can also be introduced as follows: 1Mup,tMPNtNt=MRStCt , Nt Despite nominal price stickiness, firms are not able to increase their prices in response to the increase in demand caused by the investment boom resulted from shocks. Therefore, the average mark-up of the economy decreases and effectively shifts the labor demand curve upwards. In this situation, consumption and working hours increase. In other words, in spite of inseparable preferences and in the conditions that the increase of working hours has a positive effect on the marginal utility of consumption (the complementarity of working hours and consumption), the co-movement of investment, production, working hours and consumption can be justified and the puzzle of consumption does not occur