Investment Options and the Business Cycle
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NBER Working Paper No. 13307*
Issued in August 2007
NBER Program(s): PR
EFG
This paper extends Lucas (1978) 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 in the adjustment-cost model. Equilibrium may be efficient even without markets for knowledge; the stock market may suffice.
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