RDP 8709: A Note on Aggregate Investment in Australia 2. Explaining Aggregate Investment

In modelling investment demand at the macroeconomic level, researchers typically adopt one of two distinct approaches – the stock-oriented approach or the flow-oriented approach. The stock-oriented approach derives the desired demand for capital stock and then posits some adjustment path for investment spending to move the actual capital stock to the desired level. On the other hand, the flow-oriented approach seeks to explain the rate of investment spending.^[2] An example of the stock approach is Jorgenson's (1963) neoclassical investment theory in which the desired capital stock is determined by the firm's production function, the demand for output, and the rental cost of capital, relying on an ad-hoc stock adjustment mechanism to explain the rate of investment. One example of the flow approach is the Keynesian accelerator model, in which the rate of investment spending is determined by the rate of change of output. Another example is Tobin's q theory.

In Tobin's q theory, investment spending is determined by equating the marginal (stock market) value of capital assets with the marginal cost of those assets. This approach is forward looking in the sense that expectations are incorporated into the market's valuation of capital assets. The theory is based on the premise that managers, in seeking to maximise the benefits to existing stockholders and hence the market value of their corporations, are induced towards investment in reproducible new or existing capital assets whenever they value those capital assets at prices which are greater than their replacement cost.^[3]

In short, Tobin argues that aggregate investment spending on additional capital assets will vary positively with q – the ratio of the market value of business capital assets to the replacement value of those assets. Accordingly, Tobin asserts that q can be used as a quantitative measure of the market's incentive to invest. If q is greater than unity, a favourable investment climate is indicated and investment spending is encouraged; conversely, a q well below unity discourages investment spending.

Although the relevant q is strictly a marginal q (the ratio of an additional unit of capital to its replacement cost) which is not observable, we can observe average q (the ratio of the market value of existing capital to its replacement cost). In testing the q theory, researchers use average q as a proxy for marginal q, implying equality between average and marginal q. Such equality holds only in the special case where each firm is a price-taker with constant returns to scale in both production and installation; if each firm is viewed as a price-maker, average q will exceed marginal q by an amount termed monopoly rent.^[4] As Tobin's q uses current stock market data about corporate enterprises in its derivation, it directly captures financial market expectations concerning future profitability and risk to corporate enterprises; it is, therefore, intuitively more appealing than alternative theories which rely on past experience only.^[5] However, in empirical work, q theory has performed rather poorly in explaining investment behaviour at the macro level.^[6]

Footnotes

For further discussion see Abel (1980). [2]

See Kopcke (1985) for further discussion. [3]

See Tobin and Brainard (1977), pp243. Note that average q can also differ from marginal q due to tax distortions. [4]

For example the accelerator model, which proposes that firm's demands for investment goods depends upon lagged values of output and capital stock. [5]

See von Furstenberg (1977) and Hayashi (1982) for overseas evidence. [6]