Abstract: Regressions of investment on Tobin's Q are misspecified in the presence of
capital gestation lags because they don't distinguish between the value of existing
capital and the value of capital at a future date. Current investment should be
determined by the anticipated shadow value of capital at the gestation horizon.
Under homogeneity conditions analogous to Hayashi[1982], this value is equal to
the forecast of an adjusted version of Q. This misspecification helps to explain
many pathologies in the literature: attenuated estimates of the coefficient on Q,
low R2, and seriallycorrelated errors. Regressions using aggregate data suggest
that (1) endogeneity problems associated with the standard regression of
investment on Q can can be eliminated by reversing the regression, (2)
forecastable changes in Q provide additional information about investment not
captured in current Q, and (3) specifications that explicitly account for
gestation lags yield capital adjustment costs of a more reasonable magnitude.
Full paper (397 KB PDF)
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Last update: June 1, 2005
