A forward-looking model of investment: Tests of "excess sensitivity" and "excess smoothness"
A forward-looking, stochastic model of investment is developed in which capital spending is driven by expectations of future demand and capital-price growth. The empirical implications of this model are similar to ones which have been associated with consumption under the permanent income-rational expectations framework pioneered by Robert Hall in the late 1970s. Namely, an expression related to the change in investment should be independent of lagged variables and should react in a predictable way to revisions in expectations of future growth rates of demand and capital prices. Both of these implications are tested. The correlation between the change-in-investment term and past information is examined for 10 different measures of capital spending, including purchases of various types of both durable equipment and nonresidential structures. Econometric tests show the change in investment to be uncorrelated with lagged demand growth under almost any definition of investment. However, lagged capital-price inflation does help to predict it in every case. The relationship between the change-in-investment term and revisions in expectations of future demand and capital-price growth is examined by comparing the variances of the two sides. It is found that investment in durable equipment is more volatile than the model predicts (i.e., relative to computed variances of the revisions in expected future values of the two determinants), but that the variance of expenditures on nonresidential structures is not significantly different from what it should be. The latter may represent the influence of long delivery lags, however, rather than a triumph of the model. In any case, it is not surprising that businesses are more hesitant when it comes to building new factories as opposed to adding machinery to existing plant space, for instance.
Assef, Sherif Tahsin, "A forward-looking model of investment: Tests of "excess sensitivity" and "excess smoothness"" (1994). ETD Collection for Fordham University. AAI9425181.