This project extends and tests empirically a new model of ideas and investments within a Real Business Cycle (RBC) framework. An investment option means a profit opportunity that requires an investment to implement and that can be postponed. It is postponable if it is a patented invention, or if it is specific to a firm so that others cannot reduce its value by copying it. The investigator develops a simple General Equlibrium model containing such options that emphasizes extensive investment such as creating capacity for making new products. The project explores several of its variations and assesses their quantitative significance.
The RBC literature has not, except in a stylized way, incorporated the notion of investment options. Yet they could help explain anomalies such as the equity premium puzzle and the volatility of investment. While explaining why Tobin's q tends to be above unity, the convex-adjustment-cost model of investment dampens investment fluctuations. The present model includes an intertemporal substitution element on the cost side - namely that an investment option can be used up today or tomorrow but not both - that retains most of the volatility of investment implied by the model with no adjustment costs. Proposed extensions are to a monopolistically competitive economy, to incomplete markets, and to intensive-margin investment.
Broader impact: The impact should reach beyond just the RBC issues. (1) IPOs and seasoned share issues can be viewed implementations of investment options by firms that are or that are about to become publicly owned; (2) The equity premium should be higher here than in the standard model because the volatility of consumption is considerably higher; (3) the extension to incomplete markets will help understand the effects on the business cycle of the apparent secular improvement of financial markets.
