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The role of endogenous capital depreciation rate in Dynamic Stochastic General Equilibrium models: Evidence from Canada

Belousova, Irina (2017): The role of endogenous capital depreciation rate in Dynamic Stochastic General Equilibrium models: Evidence from Canada.

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Abstract

This paper investigates the optimal behavior of the main real macroeconomic variables in a Dynamic Stochastic General Equilibrium (DSGE) framework augmented with a time-varying depreciation rate of capital stock and an endogenous production of maintenance goods. For this purpose I explicitly define a depreciation rate function which is positively related to the utilization rate of capital and inversely related to the ratio of maintenance to capital stock. Along the balanced growth path, the trend of the depreciation rate is driven by the steady state value of the investment-specific technology progress (IST). The Bayesian estimation exercises performed on the Canadian economy show that, in response to a positive shock on marginal efficiency of investment (MEI) which drives the economic business cycle, the model is able to generate co-movement in all the main real endogenous variables including consumption, maintenance and depreciation. The optimal paths are amplified with respect to the baseline model with a constant depreciation and no maintenance costs, and their convergence dynamics are delayed as a consequence of acceleration in depreciation through the obsolescence effect. The model also shows that, in response to a positive IST shock both depreciation and maintenance decline due to an increase in the average service life of existing capital. Finally, I include in the model a shock which affects the transformation process of final goods into maintenance goods, named the maintenance-specific technology progress (MST). In the short run, this shock is the key-driver of the growth in real maintenance.

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