Investment options and the business cycle

This paper extends Lucas (1978) to a production economy with two capital goods. It is an RBC model in which each unit of investment requires a new idea, an “option”. When options are scarce, new capital is harder to put in place and the value of old capital rises. Thus the stock market and Tobin’s Q are negative indexes of intangibles. During a boom, Q rises gradually, as options are used up. Because investment represents an exercise of options, the model has a larger intertemporal substitution incentive, and one that helps explain the high volatility of Q. In the model, equilibrium is efficient even without markets for knowledge; the stock market suffices.