Foley

American Economic Association
Portfolio Choice, Investment, and Growth

Author(s): Duncan K. Foley and Miguel Sidrauski
Source: The American Economic Review, Vol. 60, No. 1 (1970), pp. 44-63
Published by: American Economic Association
Stable URL: http://www.jstor.org/stable/1807854
Accessed: 30-03-2018 07:20 UTC
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Portfolio Choice, Investment, and Growth
By DUNCAN K. FOLEY AND MIGUEL SIDRAUSKI*
One of the basic postulates of monetary and the rate of interest. The demand for
theory and policy is that an increase in the investment cannot be derived from the
money supply raises income by exerting at demand for capital. Demand for a finite
least temporary downward pressure on the addition to the stock of capital can lead to
rate of interest. Since it is generally be- any rate of investment.
lieved that the savings rate is rather unre- Recent attempts to derive a marginal
sponsive to changes in the rate of interest, efficiency of investment schedule from a
the key to this postulate, and to the belief firms's profit maximizing behavior have
that monetary policy can affect aggregate relied largely on the assumption that there
demand and its composition, seems to be are costs to adjusting the actual to the
the existence of a negative relationship be- desired stock of capital at a fast rate; that
tween the demand for investment goods is, the addition to the capital stock which
and the market rate of interest. results from each additional dollar spent on
The micro-foundations of such a rela- investment diminishes with the level of in-
tionship, however, are very weak. It is vestment.' Alternatively, they have simply
well-known from the work on investment assumed that once a firm finds out what
theory by Trygve Havvelmo and others its optimum stock of capital is (if it exists),
that an analysis of profit maximizing be- it then adjusts the actual to the desired
havior on the part of firms can at most stock with a lag (see Dale Jorgenson); the
offer a relationship between the desired simplest of these models being the one
stock of capital and the rate of interest, in which the rate of investment is a linear
but not a relationship between the de- function of the difference between the de-
sired rate of increase in the stock of capital sired and the actual stock of capital. In
some models of economic growth, this
* Duncan Foley is assistant professor of economics
at the Massachusetts Institute of Technology. Miguel
theory requires a permanent gap between
Sidrauski died on September 1, 1968. A preliminary the desired and the actual stocks of capital
version of this paper was presented at the Conference in a state of steady growth to generate the
on Money and Economic Growth held at Brown Uni-
versity, June 1968. We would like to acknowledge the
investment necessary to maintain a con-
substantial contribution of Stanley Fischer to this stant capital-labor ratio over time when
paper. Mr. Fischer participated in many of our pre- population is growing (see Richard Nel-
liminary conversations about its substance and shape,
and undertook extensive editorial work in the later
son).
stages. We would also like to thank James Mirrlees, It is our purpose in this paper to point
Don Patinkin and Carl von Weizacker for our very out another mechanism which can deter-
helpful discussions with them on the subject of this
mine the aggregate rate of investment.
paper. The line of thought developed in this paper draws
heavily on the published and unpublished work of This mechanism depends on socially rising
James Tobin, especially in the treatment of asset de- costs to investment rather than rising
mands and prices.
costs to individual firms. We present a
Duncan Foley's work was supported by the National
Science Foundation (grant number GS 1585). The very simple model of growth in which the
views expressed here are the authors' sole responsibility, level of investment is determined jointly
and do not reflect those of the National Science Founda-
tion, the department of economics, nor those of the I For this approach see R. Eisner and R. H. Strotz,
Massachusetts Institute of Technology. J. P. Gould. and Arthur Treadway.
44
FOLEY AND SIDRAUSKI: INVESTMENT AND GROWTH 45
by the interaction of the stock of capital, which they are produced depends, of
its demand, which is treated as an integral course, on the relation between their
costs of production and the prices which
part of the demand for assets by wealth
they are expected to realize in the mar-
owners, and the flow supply of investment ket. Thus if the level of the rate of in-
goods as determined by the producers of terest taken in conjunction with opinions
capital goods. Even if the price of capital is about their prospective yield raise the
such that the marginal return to the exist- prices of capital-assets, the volume of
current investment (meaning by this the
ing stock of capital makes the stock in-
value of the output of newly-produced
stantaneously optimal, this does not neces- capital-assets) will be increased; while
sarily imply that this price makes it op- if, on the other hand, these influences
timal for producers of capital goods not to reduce the prices of capital-assets, the
produce any capital goods at all. volume of current investment will be
One advantage of this approach is that diminished. [p. 188]
it permits firms and consumers to be in Given the state of technology and the
equilibrium at each instant and still gen- stock of capital which is a result of past
erates new investment. The relative im- saving, the only variable that is unequivo-
portance of rising firm costs and rising cally related to the level of investment is
social costs in determining rates of invest- the price of capital goods. It is this em-
ment in various sectors is, of course, a phasis, together with the notion of in-
question which empirical studies must stantaneous stock equilibrium in the asset
answer. markets determining asset prices and
We believe that our model of investment yields, to be discussed below, which we
corresponds quite closely to Keynes' vi- share with Keynes' description quoted
sion of the investment process. In his re- above. When the price of capital goods is
sponse to comments on the General Theory high, the level of investment is also high;
he states: while if the price of capital is low, invest-
The owner of wealth, who has been in- ment is also low. This would seem sur-
duced not to hold his wealth in the shape prising if we look at the investment func-
of hoarded money, still has two alterna-
tion as an ex ante demand relationship
tives between which to choose. He can
lend his money at the current rate of
because one would then think that the
money-interest or he can purchase some higher is the price of capital, the lower will
kind of capital-asset. Clearly in equilib- be the level of investment. This result is'
rium these two alternatives must offer not at all surprising if we think of the in-
an equal advantage to the niarginal investment function as an ex post supply re-
vestor in each of them. This is brought
lationship. The higher is the relative price
about by shifts in the money-prices of
of capital, the larger will be the share of
capital-assets relative to the prices of
money-loans. The prices of capital- the economy's total resources that pro-
assets move until, having, regard to their
ducers will find profitable to allocate to the
prospective yields and account being production of investment goods, and there-
taken of all those elements of doubt and
uncertainty interested and disinterested
fore, the higher will be the rate of capital
advice, fashion, convention, and what accumulation.
else you will, which affect the mind of We do not, however, assume the ex-
the investor, they offer an equal, ap- istence of a negative relationship between
parent advantage to the marginal in- the desired level of investment and the
vestor who is wavering between one
market rate of interest and we show that
kind of investment and another....
Capital-assets are capable, in general, such a relationship may not even exist be-
of being newly produced. The scale on tween the actual, ex post, rate of invest-
46 THE AMERICAN ECONOMIC REVIEW
ment and the market rate of interest.2 their assets is equal to the value of the
Other things equal, an increase in thle rate desired additions. That is, our equilibrium
of interest lowers the demand for capital theory of investment does not assure the
on the part of wealth owners, decreasing equality of the flow supplies and demands
on this account the equilibrium price of for each of the assets at the current equilib-
capital and thus lowering the optimum rium prices. Since markets clear at each
level of output in the investment goods moment of time, the process of wealth
sector. Other things, however, are not accumulation will generally require prices
usually equal. The rate of interest is itself to change over time. Actual price changes
an endogenous variable of the system. A and expected price changes affect demand
change in the rate of interest implies that and supply schedules which in turn modify
some other variable in the system has equilibrium prices over time.
changed, and the change in this variable In the last section of this paper we
may have increased the demand for capital. study the full dynamic behavior of the
Although we conclude that there may be economy over time using a particular ex-
neither an ex ante nor an ex post negative pectations hypothesis which has been em-
relationship between the level of invest- ployed previously by other authors. In
ment and the market rate of interest, this this model we show how actual and ex-
does ntot imply that the effects of monetary pected price changes interact while port-
policy on aggregate demand or its compo- folios are adjusted to make room for the
sition are unpredictable. On the contrary, newly supplied assets. In the context of
we shall prove that monetary policy is able this model, we also study how monetary
to change aggregate demand and its com- and fiscal policy are able to stabilize ag-
position by affecting the price of capital at gregate demand so as to maintain a con-
which wealth owners are willing to hold stant price level and how changes in the
the existing stock of capital. Monetary mix of fiscal and monetary policy affect
and fiscal policy jointly not only are able the economy's long-run capital stock by
to affect the rate of growth by changing the modifying the price of capital at which
relative price of capital, but they can also wealth owners are vwilling to hold the ex-
succeed in maintaining a constant price isting stock of capital at any point in time.
level while at the same time determining
the economy's rate of growth.
I. The Demandfor Capital Services
Once the equilibrium level of investment
is determined, we go on to consider the Language itself presents several traps
process by which capital and other assets in thinking about investment, especially
find room in private portfolios. Instan- confusion between the demand for capital,
taneous market equilibrium ensures that, the demand for capital services, and the
given the state of expectations, wealth demand for investment. It seems to be ap-
owners are willing to hold the existing propriate to sort out these concepts at the
stocks of assets and that their desired and start.
actual savings are equal. It does not, how- The simplest notion is the demand for
ever, guarantee that at tlle market clearing capital services. This is analagous to the
prices the value of the addition to each of demand for the services of any factor of
production, and arises indirectly from the
demand for output. Capital services have
I J. G. Witte takes a similar approach to ours but
the dimension of a rate or flow: the use of
concludes with an ex post relationship between the rate
of investnent and the market rate of interest. such and such a machine or building for
one hour, week, or month. The price which

is determined in the market for capital
services will be called the rental rate. It is
measured in value units per hour, month,
or year, like the wage rate.
Producers will demand at any wage-
rental rate combination those amounts of
capital and labor services which will equate
their marginal products of capital and
labor to those rates. In thinking about 0
equilibrium in the market for capital ser-

vices, we are free to ignore all matters con-
cerned with the ownership of capital. A
producer trying to equate marginal pro- FIGURE 1
ducts to the prices of factor services is

making a decision which is entirely di-
bile between the two sectors, these two
vorced conceptually from consideration of
must be equal at each moment of time:'
owing capital. It may be that taxes and
other market imperfections distort pro- (1.3) f(kc) = pJ '(kr).
ducer choices but in principle the producer
in deciding his productioni plan does not In the two-sector model, the per capita
care who owns the capital. He decides en- supplies of consumption and new capital
tirely on the basis of the market rental goods depend only on the per capita stock
rate, which will be the same whether he, hisof capital and the relative price of capital.
competitor, or the King of Siam owns the
(1.4) qc = qc(k,pk)
machines and buildings.
A simple model which exemplifies these (1.5) q = qI(k, bk)
distinctions is the well-known two-sector
These supply relations are pictured in
model of production. One sector produces
Figure 1 where the production possibilities
investment goods, I, and the other pro-
curve and the price line corresponding to
duces consumption goods, C. We take the
Pko are shown.
consumption good to be the numeraire and
The per capita stock of capital, k, de-
denote the consumption price of capital
termines the production possibility locus,
goods by pk (see T. M. Rybczynski).
and price of capital determines the alloca-
In this model the demand for the services
tion of resources between the production of
of capital and labor will be determined by
capital and consumption goods.
the familiar marginal productivity condi-
An increase in the price of capital in-
tions, which bear no relationship to the
creases output in the investment goods
ownership of factors. The rentals to capital
sector. From Figure 1, we see that as
in the two sectors under competitive coni-
Pk increases from Pko to Pk1, output of
ditions are the marginal value products of
capital: investment goods increases from q;0 to
3 Here, and for the rest of this paper, we neglect cases
(1.1) rc =f(kc) = r of specialization. In fact, the conclusions presented later
(1.2) rI pkfI (kI) in this paper carry through under such conditions. In
the diagramns we use, pi as the price at which specializa-
tion to investment goods takes place, and Pk as the
If, as assumed, capital is perfectly mo- consumption goods specialization price.
Pk
that the government hires the services of
capital and labor in the market, paying
Pk -
the going market rental and wage rates,
and produces a public consumption good.
We can think of national defense or police
services as being the public consumption
good produced by the government. In
order not to complicate the analysis, we
assume that private and public consump-
tion goods are produced by "the same"
homogeneous production functions: that
is, given any relative factor prices, both
commodities are produced with the same
ql amount of capital per unit of labor.
FJGURE 2
This special assumption allows us to
write the production relations for the
private sector
qi,. Hence
(1.8) qr" = qI (k, pk)
(1.6) -<0 > 0
Opk OPk
(1.9) qc = qc(k, pk) -e
These relationships are fundamental to
where qc is the production of private
the theory of investment: for any level of
consumption goods and e is the production
the stock of capital, the output of invest- of public consumption goods. That is, we
ment goods is positively related to the
assume that private and public consump-
price of capital. This is the supply curve
tion goods are perfect substitutes in pro-
for investment goods, shown in Figure 2. duction.
Since we assume that consumption goods
are capital intensive (kc> kr), by the well- II. The Demand for the Stock of Capital
known Rybczynski theorem.
The demand for capital is distinct and
quite different from the demand for capital
(1.7) qc> ? kq < services. Capital has the dimension of a
Ok Ok
stock: so many machines or buildings. It
In this example the market for capital has no time dimension. The price which
services can always instantaneously come clears the market for capital goods is the
into equilibrium for any stock of capital price of capital, and it is measured in
and any price of capital. There is no need value units per machine or building.
in this case for any notion of the "desired" We note again that there is no necessary
as opposed to "actual" flow of capital connection between ownership of capital
services. Rentals will always move so that and the use of capital services. It is possible
firms are content with the existing flow of to use capital one does not own by renting
services. It appears to us that the same it; and possible to let out owned capital to
principle carries over to cases where there other people to use. If we take account of
are many sectors and many types of capital this, the motive for holding capital is the
goods. stream of income which it is expected to
We have so far ignored the production produce in the form of rentals, implicit or
activities of the government. We assume actual. We want to emphasize what ap-
pear to us to be two quite different kinds of sider an economy with three assets: money,
decisions: how much capital services to bonds, and capital. We can write very
employ, and how much capital to own. generally the demand functions for these
If we insist on income as the motive for as:
holding capital, the demand for capital is
essentially an asset demand, and the price
(2.1) mpm mdp_ L(a, q, Pm, Pb, Pk);
of capital will settle so that the demand for OL aL aL
1> >0O, ->O, ->O,
capital as an asset equals its given supply. da aq 0pm
The fact is that very often the same firm
AL aL
owns and employs the same capital. When -< 0, - < 0
this happens, we want to divide the firm's 9Pb dp
decision into two parts, a production
decision and a portfolio decision. (2.2) bpm = bdpm-_ H(a, q, P
Momentary equilibrium in the asset aH > aH aH
markets is possible only when wealth --, <0 , <0,
da < dq dpm
owners are content just to hold the existing
stock of capital (and supplies of other aH aH
->0, -<0
assets) at going rates of return. This in- OPb (PA
stantaneous equilibrium can be reached,
given the value of money, by an adjust- (2.3) kpk = kdpk J(a, q, pm Pb, Pk);
ment of the price of capital and interest
rates, or given the price of capital, by an 1> - >0, - <O, - <0,
adjustment of interest rates and the value Oa dq OPm
of money.4 Of Of
There may actually be many combina- < 0, -> 0
aPb aPk
tions of the price of capital and the value of
money that instantaneously equilibrate with
the asset market, and to each such com-
bination, there corresponds an equilibrium (2 a = kpk + (b + m)pm kpk
interest rate. If either price is prevented -kdpk + (bd + Ind)pM
from moving, the other may still be free to
where superscript d represents demand, m
find an equilibrium level. Only in the case
is the per capita quantity of money, b the
in which both the value of money and the
net quantity of government bonds out-
price of capital are prevented from chang-
standing, the H function is the net demand
ing, will there be any reason to think of
function for bonds by the private sector,
disequilibrium in the asset market. Only in
pm the price of money in terms of consump-
this case is there any reason to allow for a
tion goods (the inverse of the price level), a
difference between the desired stock of
the per capita value of assets, q the per
,.capital and the actual. If prices are flex- capita level of income measured in con-
ible, either the value of money or the price
sumption goods ( qc+ pkqI) , subscripted p's
of capital or both will shift to make wealth
stand for the rate of return on the respec-
owners, or their agents the firms, content
tive assets, and g is total government debt,
to hold the existing stock of capital at each
including the money stock, outstanding.5
instant.
As a specific example of this fact, con-
5 In writing the per capita demand for assets in (2.1)
to (2.3), we are ignoring distribution effects, that is, we
I Cf. the earlier quotation from Keynes. assume that aggregate portfolio decisions are indepen-
Equation (2.4) is the wealth constraint; at the investment goods sector, which is the
any instant the per capita value of assets income wealth owners obtain from renting
demanded must be equal to the per capita a dollar's worth of their capital to business
value of assets held. firms. As we have already shown above,
The value of assets held, a, enters the the rentals rate per unit of value of capital
demand functions since it is the wealth depends only on the price of capital goods;
constraint. We make the assumption that a rise in the price, by shifting resources to
the marginal propensities to increase hold- the labor-intensive sector, increases the
ings of money and capital out of any in- capital intensity in both the consumption
crease in wealth are positive but do not and the investment goods sectors and
exceed unity, while net holdings of bonds lowers r(pk)/pk. The second component of
may either rise or fall as wealth increases. the rate of return to capital is the expected
Income enters the demand functions as a capital gain on the unit of capital, equal to
measure of the transactions demand for the rate at which the consumption price of
money. Cash balances yield a return in capital is expected to increase over time,
kind if payments and receipts do not 7rk. It then follows that we can write the
exactly match for the average wealth rate of return to capital as: pk=r(pk)/
holder, or if there is uncertainty about the pk+Wk.7
timing of payments and a cost to switching We assume that money holdings earn no
from cash to bonds. Many measures of this interest. There still is, however, the
return have been proposed, such as the possibility of capital gains and losses on
aggregate value of transactions, or dis- money due to changes in the price level.
posable income. We choose to measure it Since we take consumption goods to be the
by real income in terms of consumption numeraire, we work with the consumption
units, q= qc(k, pk)+Pkqr(k, pk). Real in- goods price of money, pm. This is equal to
come rises with the price of capital.' the amount of goods a single unit of money
We assume that an increase in the level will buy, and is the inverse of p, the price
of income increases the demand for money. level. We call the expected rate of change
But at any given level of wealth and rates in pm, rm, and this is equal to the negative
of return on assets, an increase in the de- of the expected rate of inflation. An in-
mand for one asset must involve a decrease crease in the expected rate of inflation
in the demand for at least one other asset. means a fall in 7rm; money will be losing
In fact, we assume that neither the de- value faster. The rate of return to money,
mand for bonds nor that for capital in- Pm, is just equal to 7rm.
creases when the level of income rises. To simplify the analysis, we assume that
The remaining important variables are bonds have a fixed demand money price
rates of return. One dollar invested in real and a variable interest rate, like a savings
capital yields a return of pk which has two account or a call loan. Bonds may be is-
components. The first is r(pk)/pk, the sued by the government or by individuals
rentals rate per unit of value of capital, and these two instruments are assumed to
equal to the marginal product of capital in be perfect substitutes. We measure the per
capita quantity of bonds, b, in money units
dent of the distribution of wealth and income in the 7Where there are positive transactions costs, the
economy. quantities demanded will generally depend not only on
6 To see this, examine Figure 1; income in consump- the current rental but also on the expected future path
tion units is the intersection of the price line with the of this variable; in order to simplify the analysis, we
vertical axis, and this increases when pk rises from pk, include only the current value of this variable in the
to Pk,. demand functions.
FOLEY AND SIDRAUSKI: INVES1'MENT AND GROWTH 51
since a bond can always be turned into one As of any instant, the expected rates of
unit of money. The interest rate, i, is de- change in the prices of capital and money
termined in the market so that private are given, as are the stock of capital, the
individuals are content to hold the net stock of debt and, from the viewpoint of
amount of bonds the government has the private sector, the composition of the
issued. The net quantity demanded may debt as between money and bonds. We call
be negative, since at low interest rates on the ratio of total debt to money supply, x
bonds, private individuals may want to where
borrow from the government to hold
money or capital. Since the value of a
(2.5) x = gim
bond is fixed in money terms, changes in At any instant of time the government can
change x by open-market operations,
pm will also give rise to real capital gains or
losses on bonds. The rate of return to altering m while keeping g constant. We
bonds is Pb=i+Xrm, the interest rate plus will discuss the determination of the im-
the expected real capital gain from holding portant variables, Irk and rm, when we
the bond. examine the problem of equilibrium over
We also assume that the three assets are time.
gross substitutes; that is, that an increase Using (2.1) and (2.3) we can find the
in the rate of return on the one of them pairs of (Pmn,Pk) that equilibrate the assets
raises the quantity demanded of this asset markets for any supplies of money, bonds,
while it lowers the amount asset holders and capital. This is the "aa" schedule of
want to invest in the other two assets.8 Figure 3, and it is in general upward
If all returns were perfectly certain, sloping.9 As the value of money, pm, rises,
wealth owners would hold both real capital total wealth rises thus increasing the de-
and bonds only if they had the same rate of mand for capital; to offset this excess
return. The two assets would be perfect demand, the rate of return on capital pk
substitutes and market equilibrium would must fall, and so pk must rise until wealth
require Pk=Pb, which in the absence of holders are again content to hold the
expected capital or losses reduces to existing capital stock.
r(p)/pk= i, the Wicksellian equality of Note
the that a determinate interest rate
natural and the market rate. In our model corresponds to each point on aa, though we
we do not assume that returns are per- 9 Differentiation of (2.1) and (2.3) using numerical
fectly certain, so that wealth owners, who subscripts to indicate the partial derivatives with re-
are assumed to be risk averters, will in spect to the ith argument yields
general diversify their portfolios. m -Lig Li
Equilibrium in each of the three markets dpAI iJg 'A

requires that the quantities demanded and dpm aa a~~q aPk*
dPm va Lik + L2- - + Lg -k L4
supplied of each of the assets be equal,
that is, m= nd, b=bd, and k=kd. But, clq aPk
(Ji-1)h+J2-+J_- J'
from (2.4) it can be seen that if the markets aPk aPk
for any two of the assets are in equilibrium,

The denominator is unambiguously negative while the
then the market for the third will also be in
numerator is definitely negative if m>Llg. Rewriting
this condition as [(L1a/m)g/a- 1 ]m<0, we notice that
equilibrium. We can, therefore, work with
the bracketed part of the first term is the wealth elas-
any two of the markets, and we choose to ticity of the demand for money. Since there is no empiri-
exclude the bond market. cal evidence to suggest that the wealth elasticity is even
close the inverse of g/a, which in the United States is
8 The assumption of gross substitutability is made by around 6, we are justified in assuming that the inequal-
James Tobin. ity holds. Then "aa" is upward sloping.
money. At the present time, this decision

Pk Y is well understood only on the assumption
a/
of perfect certainty about the future course
of prices and rates of return, although
recent unpublished work has extended this
understanding to the case where asset
holders have given subjective notions of
the distribution of returns from assets.
This is an assumption we do not wish to
0
make in this paper. At this stage, we have
P __ _ _ _a _ _ I_ _ ____ to confess our inability to provide a satis-
factory answer, and offer instead a plaus-
ible, empirically acceptable demand func-
PM0 Pr,, tion without supplying any theoretical
derivation of it.
FIGuRE 3
We assume that consumption demand
is a function of disposable income and
cannot in general say how the interest rate wealth. This general formulation includes
varies as we move along aa. Consider a as a special case consumption functions
movement up the aa schedule; the increase without wealth, so that our main lines of
in p. creates excess demand for capital and argument do not depend on the presence
under reasonable conditions (the condition of wealth affects on consumption. We ig-
on the wealth elasticity of demand for nore variables such as rates of return which
money in footnote 9), it also creates an may influence consumption. Substantial
excess supply of money: if the increase in rate of return influences on consumption
pk which equilibrates the capital market may upset some of our findings; at the
still leaves excess supply in the money present time, though, there appears to be
market, the interest rate will have to fall little empirical evidence that rate of return
to equilibrate the money market (the influences are important in comparison to
change in the interest rate will also affect the factors we do include. We write our
the capital market) and vice versa. consumption function as:10
III. The Consumption Goods Market and ac 9c

(3.1) c-=c(a, y) -> 0, -> 0
Instantaneous Equilibrium da ay
For the whole system to be in equilib- where y is disposable income.

rium at any instant, the pair (ppm, pk) Disposable income per capita is the sum
chosen for the asset market must also
of the following components: per capita
equilibrate the demand and supply for factor earnings, which are equal to the per
consumption goods. We now come to the capita value of output measured in con-
question of the determinants of the ag- sumption goods; the value of net govern-
gregate demand for consumption goods. A
ment taxes and transfers (including inter-
satisfactory theoretical answer to this est on bonds), which is equal to the real
question would describe the decision which
value of the per capita deficit, dpm less real
the consumer makes in dividing his dis-
posable income among the alternatives 10 We thus assume that private and public consump-
tion goods are independent goods in consumption;
facing him: he can buy consumption goods our earlier assumption was that they were perfect sub-
or save by purchasing capital, bonds, or stitutes in production.
government expenditure e; and expected increase in pk would have to be accom-

capital gains or losses on existing assets panied by a fall in pm to maintain equilib-
from changes in prices. rium in the consumption goods market.
The resultant cc schedule is shown in
(3.2) y = qc(k, pk) + Pkqr(k, Pk) Figure 3.
+ (dpm- e) + 7rmgPm + rkkPA The intersection of the aa and cc sched-
Thus for the consumption goods market ules gives the prices of capital and money,
to clear, we have Pko and pm0, which equilibrate the assets
and consumption goods markets. A de-
c = - e = c(a, y) terminate interest rate corresponds to the
(3.3) = c{a, [qc + Pkqr + (d + irmg)pm pair (Pk,, pmo) so that the instantaneous
equilibrium of the economy is fully deter-
+ 7rkkpk-e]} = cd
mined. The equilibrium price of capital
From (3.3) we obtain a "cc" schedule of also determines the flow supply of invest-
pairs (pm, pPk) which clear the consumption ment goods. Every market is in equilib-
goods market. An increase in pk will pro- rium, there is no divergence of a desired
duced excess demand for consumption stock of capital from the existing one, but
goods on three counts: first, it reduces profit maximizing suppliers of investment
production of these goods; second, it goods will generally be producing a flow of
increases the value of wealth and the new investment. The higher the equilib-
wealth effect leads to an increase in the rium price of capital, the larger this supply
demand for consumption goods; and third, will be.
it increases income measured in consump-
tion goods. On the other hand, if 7rk iS IV. Government Policy
negative, an increase in pk would reduce The government can use its policy vari-
demand by reducing the value of expected ables to influence the positions of the aa
gains, or by increasing the amount of and cc schedules and determine the equilib-
capital which has to be devoted to main- rium prices of capital and money and the
taining the stock of wealth. We shall output of investment goods. Monetary
assume that the first three factors out- policy operates through open market
weigh this fourth effect if 7rk is negative.1' operations, changing the composition of
Of course, if Tk iS positive, there is no the outstanding government debt. An open
ambiguity. An increase in pm tends to market purchase, for instance, increases
increase consumption demand by increas- the supply of money and reduces that of
ing the value of wealth, and also tends to bonds. A pure fiscal policy would be that of
increase demand if (d+irmg) is positive.'2 the "marginally balanced budget" in
Thus if (d+?rmg) is positive, an increase in which the deficit is kept constant and net
pm definitely produces excess demand in the taxes and expenditures are varied; we call
consumption goods market. In this case, an this "pure" because it leads to no changes
in the supply of debt over time compared
11 In fact, in the steady state pk will be constant so with what that stock would otherwise have
that we would expect 7rk to be equal to zero. Then the been. A deficit financed fiscal policy is one
possible arising from the 7rk term disappears.
12 The effects of an increase in pm are ambiguous in the
which involves changes in the deficit and
case where (d+irmg) is negative. We do not analyze so over time produces a different debt from
this case here since the typical long-run behavior of an that which would otherwise have prevailed.
economy with a positive outstanding stock of govern-
ment debt requires that (d+rmg) be positive to main-
It is easy to see that an open market
tain a positive real debt over time purchase, for instance, raises the aa sched-
ule and leaves the cc unchanged under transfers plus government expenditures,
our assumptions, which leads to a higher
(5.2) dpm = VPm + e
Pk and a lower pm. Expansionary fiscal
policy of any kind moves the cc downward
and we know that
and leaves the aa unchanged, lowering
both pk and pm in equilibrium. Since the DKO
(5.3) q = qiPk 4- qc-- Pi, + qc
interest rate may move either up or down N
along the aa schedule, there may be no
consistent relationship between the level Using these two facts in (5.1) we get
of investment and the interest rate, even
DKI
ex post. N Pkq4 c Pc e +dpm
V. Stock-Flow Equilibria
(5.4) DGd DKY
Once the producers' equilibrium level of
CdG + Dp d
output in the investment goods sector is
determined, it is natural to ask whether Since the deficit is equal to the rate of
wealth owners will absorb this real capital increase in the government debt, we can
into their portfolios at the equilibrium write (5.4) as
prices and interest rate. We can ask the
same question about the government DK8 DG8
deficit, which increases the outstanding (5 5) p N Pmp + qc-e
stock of government debt. The fact that
DKd DGd
actual and desired stocks of capital,
=Cd + Pk + Pm
money, and bonds are equal at certain N N
prices does not guarantee that people will
But when the consumption market
be content to absorb any given increases
clears, qc- e is equal to Cd, so that we get
in the stocks, even though the demand and
the equality of total supply of new assets
supply of consumption goods are equal. If
and total desired acquisitions.
people are not content to absorb the given
additions, how will the new supplies of DKS DG8
capital and other assets find room in pri- (5.6) Pk + P mPM
N N
vate portfolios?
To begin with, we note that the private DKd DGd
sector income budget constraint requires Pk + ptn
N\r N1
that private disposable income equal the
private demand for consumption goods If we add the capital gains terms to both
plus the value of desired additions to asset sides of (5.1), we see that consumption
holdings, at current prices. market equilibrium implies that at the
equilibriunm prices desired and actual sav-
DKd DGd
ing are equal. Rewriting (5.6) we have
() 4- VP. pm - + _ Pk + Pm13
P'r [q-DKd1
where G =Ng and v is the per capita nom- pk Pq m N
inal net transfers to the private sector
including interest on government bonds. DG d
= pm -- d
The budget deficit is in turn equal to net
13 We use the operator D to denote the time deriva- (5.7)DGd G8

tive of a variable. The variable d denotes the per capita = DG PMs
deficit. N is the labor force.
FOLLY AND SIDRAUSKI: INVESTMENT AND GROWTH 55
This indicates that it is possible for in- tal and new debt. Prices may be changing,
dividuals to be content to hold existing but at every instant all markets are in
stocks of capital and debt, to purchase the equilibrium and there is a determinate rate
quantities of consumption goods desired, of investment.
and therefore to be accumulating in total The growth of portfolios and the absorp-
the value of assets they wish to accumu- tion of capital and debt by saving are
late, but at the current equilibrium prices dynamic processes which can be studied
to desire to add to their stocks in propor- only through time and which generally
tions which are different from the rates at involve changes in the prices of capital and
which these stocks are being supplied. money and the interest rate. Accordingly,
From (5.7) we see that if the government is we must now proceed to a full dynamic
increasing the supply of debt more rapidly analysis of this economy.
than wealth holders wish to accumulate it
at the current prices, wealth holders will be VI. Equilibrium Through Time
accumulating capital more slowly than and Expectationts
they wish to: a flow excess supply of debt We have proposed a theory of the de-
is accompanied by a flow excess demand termination of the instantaneous rate of
for capital. investment which separates firm decisions
In fact, even if DGd/N= d, so that wealth into three parts: a producer's decision as to
holders are accumulating just the amounts the amount of capital to employ; a port-
of capital and debt that they desire, they folio decision as to the amount of capital
may not be accumulating debt in the to own; and a supply decision as to the rate
desired proportions. We have of production of capital goods. This tho-
rough-going equilibrium analysis has
DGd DMfd DBd
brought us to the paradox that the flow
N N N supplies and demands of assets may not be
and equal at the current equilibrium prices.
Before we discuss the solution of this
DGs DM, DBt paradox, one example may be helpful: the
d3 -=- +
N N N housing market. At any instant of time,
the services of the housing stock are of-
and the equality of DGd/N and d does not fered inelastically and the rental to housing
imply that the actual rate of change of the is determined by the demand for these ser-
quantities of money and bonds are equal to vices; at the same time the existing stock
desired rates of change. of houses must be held in wealth owners'
The results of any difference between portfolios and the price for houses will be
actual and desired rates of change of asset that price which just makes wealth owners
holdings will clearly be changes in the price content to hold the existing stock. Build-
of capital (and its rate of return), the price ers make their decision to supply new
of money, and the interest rate over time. houses on the basis of the going market
If we insist on a complete dynamic model price. As these houses come onto the
in which the asset markets are always in market, they will be absorbed into port-
equilibrium, the supply of capital at every folios. If, however, at the existing price, the
instant is the integral of past investment, rate of change of the stock demand is not
and the supply of debt is the integral of equal to the flow supply, the price of
past deficits, then the three variables houses will have to change over time to
Pk, pm and i must follow paths which allow accommodate these increases in the stock.
for the voluntary absorption of new capi- The moral of this example is that the
price of capital and/or the value of money the assets and commodity markets is al-
will have to change through time as we ways achieved. The paradox of the last
move through a succession of instantaneous section is partially resolved. There is no
equilibria. Let us focus for a moment on need for desired and actual flows of assets
the idea of a succession of instantaneous to be equal at current equilibrium prices if
equilibria. These will form a path for all asset prices are free to move.
the variables in the system. Is any path But they are not free to move arbi-
which satisfies the instantaneous equilib- trarily because the actual rates of change
ria at every moment admissible? Clearly in pm and Pk will influence the expected
not. There are important restrictions on rates 7m and Tk. There are three popular
the way the instantaneous equilibria fit models of this process, "static expecta-
together. In a continuous time model, tions," "adaptive expectations," and "per-
these are restrictions on the derivatives of fect foresight."
the variables. Perfect foresight requires Wm= Dpm/pm
For example, the capital stock at any and lrk=Dpk/pk at each moment on the
instant is the integral of past instantane- whole path. If in addition we were to
ously determined rates of investment. specify equations describing the time
Likewise, the stock of outstalnding debt is paths of the policy variables d, x, and e, we
the integral of past deficits. These re- would have a complete system of eleven
strictions turn the instantaneous equilibria equations in eleven unknowns, determin-
into a system of differential equations. ing fully the time path of the economy.
At any instant the rate of change of the While the assumption of perfect fore-
per capita stock of capital is equal to the sight in problems of intertemporal econo-
per capita output of investment goods mics seems to be a natural extension of the
minus the amount of investment needed to assumption of perfect information usually
provide individuals entering the economy made in static equilibrium models, it
with the existing per capita level of capital. imposes severe restrictions on the system
and its path. First, it rules out all notion of
(6.1) Dk = qr(k,pk)- nk
of uncertainty and portfolio diversifica-
where n is the rate of increase of the labor tion; second, it requires assumptions about
force. information which are unlikely to be met
Similarly, the rate of change of the per in reality; and third, and most important,
capita government debt is equal to the it leaves almost no room for discretionary
deficit minus the amount of new debt government policy. A strong condition on
needed to maintain a constant amount of government policy which is consistent with
debt per capita perfect foresight is that future government
policy is known and therefore unalterable.
(6.2) Dg=d -ng
In this case, the complete paths for policy
Together with (2.1), (2.3), (2.5), and variables are determined from time zero,
(3.3), these constitute a system of six and no further change can occur without
equations in eleven unknowns, k, g, m, x, violating the perfect foresight assumption.
Pk, in Pm, 7k 7rm, d, and e. Obviously such a Government discretionary policies are
system has many possible solutions; it is consistent with perfect foresight when they
underdetermined. Any paths for the eleven do not induce regrets in economic agents.
variables which satisfy the six equations But even with this weaker condition, most
are admissible. On each such path pk and of the policies considered in the analysis
pm will be changing so that equilibrium in of Section V, which seem to be the types of
policy most government use to control manipulates either the composition of the
aggregate demand and its composition, debt (monetary policy) or the levels of
would be excluded because they do induce expenditure and taxes (marginally bal-
regrets. anced budget fiscal policy) to achieve a
In the other models of expectation stable consumer price level, so that
formation, where actual price changes
influence expected price changes either not (7.1) pm pm
at all or with a lag, there will not be an in- To simplify matters, we assume that the
tertemporal competitive equilibrium, only government maintains constant the out-
a succession of instantaneous equilibria standing stock of nominal debt by fixing
based on possible wrong guesses about the its deficit at the appropriate level.
future. There is a larger sphere for dis-
(7.2) d - ng*
cretionary government policy and the set
of solution paths becomes wider. There will Given a constant price level over time, it is
also be regrets which imply that individ- reasonable to assume that the expected
uals and firms are not in intertemporal rate of change of pn is equal to zero:
equilibrium. They will be in instantaneous
equilibrium given their imperfect informa-
(7.3) 7rtn - 0
tion about the future. If monetary policy is used to stabilize
It seems to us, then, that the require- the price level and fiscal policy is passive
ment of intertemporal competitive equilib- we have an additional equation
rium is very strong, and requires assump-
(7.4a) e= e*
tions about information which are un-
likely to be met in reality. There seems to while if fiscal policy is used to control the
be a place for a theory that allows for a price level and monetary policy is passive,
lack of intertemporal equilibrium while the additional equation is
insisting on instantaneous equilibrium.
(7.4b) x= x*
Static expectations models, however, are
too naive, particularly where prices may We have two possible models, depending
actually be changing in the economy. on whether we use (7.4a) or (7.4b); both
Accordingly, in the following section we of them are summarized in systems of ten
analyze two models using the adaptive equations in the eleven unknowns: the six
expectations hypothesis which allows for mentioned in Section VI plus (7.1) through
errors and attempts to correct these errors (7.4).
on the basis of newly available informa- In both models we are missing an equa-
tion."4 tion describing the process by which
wealth owners and consumers form their
VII. Dynamics
expectations about the rate of change in
In order to analyze the relationship the price of capital. Since they are not
between the prices of capital and money, assumed to have perfect foresight, they
the rate of interest and stocks of different will tend to make mistakes which they will
assets over time, we consider two simple probably try to correct as new information
dynamic models. In both of them we becomes available to them. A simple model
assume that the government actively of this type is the adaptive expectations
model in which the rate at which people
14 A version of the adaptive expectations hypothesis
has been used by one of the authors in an earlier growth
adjust their beliefs about the rate of change
model. See Sidrauski. of the price of capital depends on the error
made in predicting the current rate of Stabilization of the Price Level Through a
change: Marginally Balanced Budget
In this case, given the stock of capital

(7.5) Dwk [Dk k] inherited from the past and given the
pk
expected rate of capital gains based on the
A standard policy argument is that an past behavior of the price of capital, equa-
easy monetary policy combined with a tions (7.1) and (7.2) determine the price of
tight fiscal policy will promote growth, capital and the interest rate which equilib-
while a tight monetary policy together rate the assets markets.
with easy fiscal policy encourages con-
sumption at the expense of investment. (7.6) Pk = '(k, 7rk; g*pxX)
The degree of ease or tightness is probably
with
thought of in terms of the level of "the"
interest rate or the general level of interest
Opk < Pk > 0 P < O 15
rates. We have shown, however, that there
ck Xrk Ox
is no necessary relationship between the
interest rate and the price of capital which Given pk determin
determines the output of investment goods kets, equation (3.3) indicates the level
at each instant. We choose to define an of government expenditure, e, consistent
easy monetary policy in terms of the com- with equilibrium in the commodity mar-
position of the debt: an increase in the ket for p* and the asset market equilibrium
proportion of money in the stock of out- price of capital.
standing debt-a fall in x-represents an Differentiating equation (7.6) with re-
easing of monetary policy. A tightening of spect to time and substituting into (7.5) we
fiscal policy is represented by a decrease in have
the level of government expenditures and
[ 1 OP
taxes while the deficit is kept constant or -- Dk - rk
by a fall in the deficit.
(7.7) Drk =- -Pak __k
In this section we shall consider the
policy argument outlined above: first, we 1 - A3
- 8 k pk_
examine the effects of a decrease in the
debt-money ratio where a marginally
Substituting (6.1) into (7.7) we can
balanced budget fiscal policy is used to
rewrite the basic differential equations of
stabilize the price level; and second, we
the model as equations (7.8) and (7.9).
consider the effects of an increase in govern-
ment expenditures when monetary policy 15 The signs of these derivatives may be confirmed by
is used to stabilize the price level. differentiation of (2.1) and (2.3).
(7.8) Dk = qr[k, '(k, rk; g xo)] - nk
d { (- -) (q [k (k; rk; g PM) xo)] - nk) - rk}

(7.9) Drk = Ok l
iTk
(Dk-O) (Dk=O)
0 (DT?k= Q (DrTk= O) I
/ /~F // " /
r / </ rs~~4 / 4,/

k I k
i /// U / k
i /h/, {//L/
FIGUE 4
The Dk = 0 and Drk = 0 lines in Figure 4 the effects of an easing of monetary policy:
indicate the pairs (k, Ik) that make Dk and that is, an increase in the proportion of
D-n-k respectively equal to zero. Figure 4 money in the debt, equivalent to a fall in x.
corresponds to the case in which the de- We examine only the stable case shown in
nominator in equation (7.9) is positive; Figure 4. An open market purchase which
that is, the case in which the lag in the produces a fall in x leads to an increase in
adjustment of expectations is sufficiently the price of capital which clears the assets
large to avoid the perpetuation of runaway markets. In terms of the diagrams, this
boom in the assets markets.'6 shifts both the (Dk = 0) and (Dlrk = 0)
It is important to note that in this schedules to the right since the output of
model, the more slowly that wealth owners investment goods will now be higher for
adjust their mistaken expectations, the any pair (k, ITk) and a higher capital stock
more likely it is that the long-run balanced will be needed to absorb the additional
growth path is stable.'7 "8 output of investment goods in the steady
We mav now use the model to consider state. The capital stock increases con-
18 A similar stability conditioni is also to be found in
tinually to its new higher level so that the
Philip Cagan and Sidrauski. overall rate of growth will be higher in the
17 It can be proved that in this case under rather weak period of disequilibrium than in the steady
assumptions the equilibrium exists and if it exists it is
unique.
state. The expected rate of increase in the
18 Problems of stability in the assets markets arising price of capital initially falls below zero as
from a rapid adjustment of expectations lie behind the the accumulation of capital forces pk down
recent controversy on models with heterogeneous capital
goods. See F. H. Hahn, and Karl Shell and Joseph E.
after its first upward jump. The fall in 1rk
Stiglitz. depresses Pk even further for awhile, but
(7.11) Dk 3 qI[k, c?(k, 7rki g*p, dp*, e)I -n
(qz[k, 4(k, 7rk; g pm dpm, e)] - nk) -7

(7.12) D7rk9
( 7rk pk
the depressing effect of pk of

Pkthe rise
= 4?)(k, in k
Ir;gm,d, e),
diminishes as k approaches its steady state
value and Dk approaches zero. In the end (7.10) l db > d0b4 la
- 0, -< 0, -< 0
Irk, following the actual rate of change in ak < aOrk dle
Pk, moves back to zero.
What is required of fiscal policy in order Given pk determined in
to stabilize the price level following the goods market, the government has to vary
rise in the price of capital and the subse- the composition of the debt in such a way
quent accumulation of capital? For the as to ensure that the Pk determined by
reasons outlined in Section III, an increase (7.10) together with p* clear the assets
in the price of capital has an inflationary markets.
effect in the consumption goods market. Differentiatinig (7.10) now with respect
To offset the effects of the initial rise in the to time and substituting into (7.5) and
price of capital, then, fiscal policy has to be using (6.1), we obtain equations (7.11)
tightened-the level of government ex- and (7.12).
penditures and taxes has to be reduced. There are now three possible stable con-
This is what the conventional accounts lead figurations of the (Dk=O) and (D7rk =0)
us to expect. Then as capital accumulates loci depending first on whether an increase
over time, the price of capital in the assets in the capital stock increases or decreases
markets begins to fall from its new level so the equilibrium price of capital in the
that fiscal policy can be eased on this consumption goods market; and second on
account. However, the accumulation of whether an increase in the expected rate of
capital also affects the equilibrium of the change of the price of capital increases or
consumption goods market though the decreases the rate at which that expected
effects are ambiguous since an increase in rate is changing (i.e., whether or not
the capital stock increases supply and aDWk/a97Ik<O). It is a necessary condition
increases demand through wealth and in- for stability that an increase in the capital
come effects. After the initial tightening stock decrease the rate of change of the
the direction of fiscal policy is uncertain. capital stock (i.e. aDk/lk <0). This condi-
tion need not always be met in practice
Stabilization of the Price Level Through since an increase in the capital stock may
Monetary Policy increase the equilibrium price of capital in
In this case, given the stocks of govern- the consumption goods market and in this
ment debt and capital inherited from the way increase the output of investment
past, 7rk and p* and the government's goods. There are two factors working in
policy parameters e and d, the price of the opposite direction. First, the increase
capital is determined in the consumption in k by itself lowers qI. Second, the increase
goods market (3.3). in x raises k and lowers Dk. If an inicrease
iT
TrK
\ \ \ \~~~~~~\ Jo
\ (DTk=% \ (D7Tk=O)l
(Dk=O)0 (Dk 0)1
FIGURE 5
in k produces so great a rise in pk through no oscillations possible in the former case.

the consumption market that it over- Second, is the case where ODwk/d2rk >0.
whelms these negative factors, the system The stable equilibria on this assumption
will be unstable. are like the one shown in Figure 7, and the
We show the three possible stable equil- system can produce cycles.
ibria in Figure 5, 6, and 7. In each diagram We are now ready to examine the effects
the (Dk= 0) locus is downward sloping of a tightening of fiscal policy, that is, a
since an increase in the capital stock re- decrease in the level of government ex-
duces the rate of change of the capital penditures and taxes. A decrease in the
stock, so that a decrease in wxk-which level of government expenditures with a
increases the price of capital at which the constant deficit is deflationary in the
consumption market clears-is required to consumption goods market so that the
offset this effect. The horizontal arrows price of capital which clears that market
indicate that dDk/d3k < 0. rises as for any pair (k, rk). Around a
While the Dk=O schedule must slope position of stable equilibrium this will shift
downward near a stable equilibrium, there the (Dk = 0) and (D7rk= 0) schedules to the
are two possibilities for the Dk= 0 right, increasing the equilibrium stock of
schedule. First, there is the case where capital since a higher capital stock is now
oDTk/lak < 0. In this case the Dwrk= O
needed to absorb the higher output of
schedule must have a higher slope than the investment goods in the steady state. If
Dk = 0 schedule near a stable equilibrium, the economy were initially at a position of
as illustraed in Figures 5 and 6. There are stable long-run equilibrium, the capital
k|
/ t- \ ,' L e 'I
(D rrk ?)0 (D k =)0 ( D TTk =)/ (D k )k
FIGuRE 6
L
7T'k
(Dry-O)0 (Dk=O)o(Drrk=O)D7l 0 (Dk~=o )

4N \ lb
FIGuRE 6
\ ~ (Dk )
(Dk=O)0
FIGURE 7
FOLEY ANI) SIDRAUSKt: INVESTrMENT AND GROWTH 613
stock increases to its new equilibrium level. REFERENCES

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movement to the new equilibrium capital Hyperinflation," in M. Friedman, ed.
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previous examples was a higher stock of Impacts of Mfonietary Policy, Englewood
Cliffs 1963.
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J. P. Gould, "Market Value and the Theory
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changes in the price level, but the con- of Investment of the Firm,," Amer. Econt.
Rev., Sept. 1967, 57, 910-13.
tinuing changes necessary in monetary
T. Haavelmo, A Study in the Theory of In-
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209-23; reprinted in S. E. Harris, ed., The
directions at different times.
New Econo-mics, New York 1948, 181-
These two experiments partly confirm
93.
the policy argument with which we began
R. R. Nelson, "Full Employment Policy and
this section. In the short run, tightening
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796-810.
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anzd Debt Management Policies, Englewood
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formation we used in the last section do not unpublished doctoral dissertation, Univ.
exhaust the potential of models based on Chicago 1967.
these ideas. We encourage the reader to J. G. Witte, "The Microfoundations of the
"roll his own" model out of the fixings we Social Investment Function," J. Polit.
have prepared. Econ., Oct. 1963, 71, 441-56.

Foley

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American Economic Association

Portfolio Choice, Investment, and Growth

one hour, week, or month. The price which

equilibrium in the market for capital ser-

ducts to the prices of factor services is

general diversify their portfolios. m -Lig Li

Equilibrium in each of the three markets dpAI iJg 'A

for any two of the assets are in equilibrium,

money. At the present time, this decision

III. The Consumption Goods Market and ac 9c

For the whole system to be in equilib- where y is disposable income.

government expenditure e; and expected increase in pk would have to be accom-

13 We use the operator D to denote the time deriva- (5.7)DGd G8

In this case, given the stock of capital

(7.8) Dk = qr[k, '(k, rk; g xo)] - nk

d { (- -) (q [k (k; rk; g PM) xo)] - nk) - rk}

r / </ rs~~4 / 4,/

(7.11) Dk 3 qI[k, c?(k, 7rki g*p, dp*, e)I -n

(qz[k, 4(k, 7rk; g pm dpm, e)] - nk) -7

the depressing effect of pk of

(Dk=O)0 (Dk 0)1

in k produces so great a rise in pk through no oscillations possible in the former case.

(D rrk ?)0 (D k =)0 ( D TTk =)/ (D k )k

(Dry-O)0 (Dk=O)o(Drrk=O)D7l 0 (Dk~=o )

stock increases to its new equilibrium level. REFERENCES

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(7.11) Dk 3 qI[k, c?(k, 7rki gp, dp, e)I -n