EFFECTS OF FISCAL AND MONETARY POLICIES ON CAPITAL FORMATION: A DYNAMIC ANALYSIS

Effects of fiscal and monetary policies on private capital formation have been studied extensively (e.g., Feldstein (1980), Henderson and Sargent (1973) and Tobin and Buiter (1982)). However, these studies are restricted to the analysis within a static framework in nature. They assume that firms either maximize profits in a firm's static problems or they assume firms maximize the present value of its future net cash flows without introducing adjustment costs in a perfect capital market. Because of the assumption that the firm adjusts instantaneously its stock of capital to the desired level, together with the one of no adjustment cost, they are always in steady state, i.e., they apply myopic rule. This assumption of instantaneous adjustment of capital is not realistic in a macroeconomic model because the amount of investment is restricted by the society's amount of savings.;A dichotomy between fiscal deficits and monetary policy is found in the first model. An increase in the fiscal deficits unambiguously decreases the shadow price of investment and the capital stock, and increases real interest rate both in the long run and in the short run. On the other hand, money is neutral in the first model without formulating a rational expectation hypothesis.;In the second model an increase in the fiscal deficits unambiguously decreases the capital accumulation and the shadow price of investment whereas an increase in the growth rate of money unambiguously increases the capital accumulation and the shadow price of investment in the long run. Money is no longer neutral in the second model. All the results about effects of fiscal and monetary policies on capital accumulation, rates of interest, inflation and real money supply differ immensely from those of a static analysis.;In this thesis, dynamic behavior of firms with adjustment cost of investment is studied and the investment schedule is derived as a function of its shadow price (Tobin's marginal "q") in real terms, which in turn changes over time depending on the rates of interest, depreciation and inflation, and the marginal product of capital. We have formulated two macroeconomic models. The first one is without wealth effect and the second one is with wealth effect which operates through goods market and asset market.