Research Discussion Paper – RDP 8709 A Note on Aggregate Investment in Australia
October 1987
Abstract
Investment plays an important role in influencing short-term aggregate demand and in determining the long-run growth potential of the economy. Despite the current debate concerning the potential problem of low investment, there have been few recent empirical studies of aggregate investment in Australia. The purpose of this paper is to explore the relevance of Tobin's “q theory” of investment in explaining aggregate investment in Australia, over the period from December 1966 to December 1986.
The first part of the paper derives a q theory of investment behaviour based on a model of an optimising firm facing costs to adjusting its capital stock. The second part of the paper explores the empirical relevance of the theory. In testing the q theory we relax the implicit assumption that firms have unlimited access to capital markets, allowing a proportion of aggregate investment to be determined by current profits. Using standard capital stock data, the q theory performs poorly. However, the cost of adjustment model implies that the conventional capital stock data needs to be revised to allow for these adjustment costs. Once this is done, it is found that the q theory is empirically supported. For plausible values of the cost of adjustment, the results indicate that a lower bound of 10 percent of aggregate investment is explained by q theory and 90 per cent by current profits.