. Neoclassical model of investment

Suppose that fifirms produce according to the production function Y = AK1/2L1/2 , where A = 5

and L = 400. Assume that the prices of capital and output are equal and that the real interest

rate, r, is equal to 0.25 and the depreciation rate, , is equal to 0.1.

1.

If fifirms operate according to the neoclassical theory of investment, what is the optimal

level of capital stock, K*?

2.

Suppose that the government offffers an investment tax credit which changes the relative

price of capital. This results in Pk = 3 and P = 6. What is the new optimal level of capital

stock, K*

3. Does the investment tax credit have an expansionary impact on the economy? Explain why or why not.

4. Based on the optimal capital stock computed in part (2), what is the level of investment

needed to sustain this level of capital stock?