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, 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 serially-correlated 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