Interest Rates and Investment Coordination Failures

30 Pages Posted: 13 Mar 2016 Last revised: 4 Oct 2016

Joshua R. Hendrickson

University of Mississippi; American Institute for Economic Research

Date Written: March 10, 2016

Abstract

The theory of capital developed by Bohm-Bawerk and Wicksell emphasized the roundabout nature of the production process. The basic insight is that production necessarily involves time. One element of the production process is to determine the period of production, or the length of time from the start of production to its completion. Bohm-Bawerk and Wicksell emphasized the role of the interest rate in determining the period of production. In this paper, I develop an option games model of the decision to invest. Two firms have an opportunity to enter a market, but production takes time. Firms face a two-dimensional decision. Along one dimension, they determine the period of production and the prospective profit therefrom. Along another dimension, they determine whether or not they want to enter the market given the amount of time it will take to start generating revenue from production. Within this option games approach, the period of production can be understood as an endogenous time-to-build and I argue that this framework provides a tool for evaluating the claims of Bohm-Bawerk and Wicksell against the backdrop of competition and uncertainty. I evaluate the period of production decision and the option to enter decision when the real interest rate changes. I show that investment coordination failures are more likely to occur at lower levels of profitability when real interest rates are low. I conclude by discussing the implications of low interest rates for boom-bust investment cycles.

Keywords: structure of production, time to build, option games, interest rates, coordination failure

JEL Classification: L13, D92, D81, C72, E22, E14, B53

Suggested Citation

Hendrickson, Joshua R., Interest Rates and Investment Coordination Failures (March 10, 2016). Available at SSRN: https://ssrn.com/abstract=2746076 or http://dx.doi.org/10.2139/ssrn.2746076

Joshua R. Hendrickson (Contact Author)

University of Mississippi ( email )

Oxford, MS 38677
United States

American Institute for Economic Research

PO Box 1000
Great Barrington, MA 01230
United States

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