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Investment: Theory, Estimates, and Public Policy

a PSC Research Project

Investigators:   Christopher L. House, Matthew D. Shapiro

This project will analyze the determinants of investment spending. It will quantify several key determinants and study how they affect investment both in theory and in practice. The proposal features two related lines of research. The first research component is an empirical analysis of investment at a disaggregated level. The second component develops and estimates a structural model of investment. The two research components are complementary. The empirical results are used to inform, test, and estimate parameters of the structural model. In turn, the structural model provides important insights into the effects of recent and future investment policies.

The first part of the project presents an empirical analysis of investment. This research establishes key empirical facts that investment theories should match. It also evaluates the empirical success of several existing theories. Specifically, using a panel of type-specific investment data, four prominent empirical issues are studied: (1) the cyclicality of pre-tax and after-tax investment prices; (2) the role of uncertainty in investment spending; (3) the response of investment to tax subsidies and (4) the response of automobile production and prices to the Consumer Assistance to Recycle and Save Act of 2009, also known as “cash for clunkers.” The primary data sets used are the BEA underlying detail tables for investment, recently available measures of economic uncertainty, and an updated, revised set of type-specific investment tax subsidies.

The second part of the proposal presents a structural equilibrium model of investment. The theoretical framework builds on previous studies which feature fixed adjustment costs at the microlevel.

The model adds to this research by introducing a new investment timing friction not featured in earlier work. The timing friction allows firm-level heterogeneity to have a substantial influence on equilibrium investment dynamics. This is a significant extension of the research on fixed costs and firm-level heterogeneity since important effects of such heterogeneity are not present in earlier models. As a result, the proposed framework will provide a better guide to analyzing investment policy. The magnitude of the timing friction will be estimated with type-specific investment data. The empirical work in the first part of the proposal will provide several parameters to assess the fit of the theoretical model and to develop estimates of the effects of specific policy changes.

Summary of intellectual merit. The project will develop a modern model of investment that incorporates key frictions that imply important firm-level heterogeneity. While the model incorporates many complex modern features, it is also analytically tractable and yields sharp testable predictions. Hence, this research will allow modern investment models to confront the data in a meaningful way and to be used to evaluate specific policies.

Summary of broader implications. This research will provide both theoretical and empirical guidance for government policies designed either to affect overall economic activity by stimulating investment or to promote investment to increase economic growth. Additionally, the results of this analysis will be valuable to studying business cycles by shedding light on how various shocks affect investment activity.

Funding Period: 05/01/2010 to 06/30/2014

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