Jonathan N. Millar
200524
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of these papers.
Gestation Lags for Capital, Cash Flows, and Tobin's Q
Jonathan N. Millar
Board of Governors of the Federal Reserve System
Abstra
t
Investment models typi
ally assume that
apital be
omes produ
tive al
most immediately after pur
hase and that there is no lead time needed
to plan. In this
ase, marginal q is usually suÆ
ient for investment.
This paper develops a model of aggregate investment where
ompeti
tive rms fa
e no adjustment
osts other than building and planning
delays. In this
ontext, both Tobin's Q and
ash
ow
an be noisy indi
ators of investment be
ause some sho
ks fail to outlast the
ombined
gestation lag. The paper demonstrates some empiri
al fa
ts that
hal
lenge prevailing theories of investment but are
onsistent with gestation
requirements. Regressions using aggregate data suggest that it takes at
least four quarters for investment to respond to te
hnology sho
ks and as
many as eight additional quarters before produ
tive
apa
ity is ae
ted.
Estimates from stru
tural VARs show that only permanent sho
ks af
fe
t investment, but that
ash
ow and Q rea
t to both permanent and
transitory sho
ks.
The author would like to thank Matthew Shapiro, Miles Kimball, Dmitriy Stolyarov,
Tyler Shumway, Bill Was
her, Darrel Cohen, and seminar parti
ipants at the University of
Mi
higan and the Board of Governors of the Federal Reserve System for many substantive
omments and suggestions. The views in this paper are solely the responsibility of the
author and should not be interpreted as re
e
ting the views of the Board of Governors of
the Federal Reserve System or its sta.
I. Introdu
tion
Investment models typi
ally assume that (1)
apital expenditures o
ur im
mediately after the rm's investment de
ision, and (2) that pur
hased
apital
be
omes produ
tive with little or no delay. These features
ontrast with pra

ti
al a
ounts of investment, where proje
ts often require
onsiderable periods
of planning and building. The planning period en
ompasses the time needed
for engineers to draw up the details, lawyers to obtain relevant permits, and
management to arrange nan
ing. Building involves the time needed for
on
stru
tion and for equipment to be ordered, delivered, and installed. Owing to
these delays, there may be a
onsiderable lag between the de
ision to in
rease
apa
ity and the
ommen
ement of produ
tion in a new fa
ility.
In the neo
lassi
al world, the user
ost adjusts to equate the (fri
tionless)
demand for
apital servi
es with supply. In this environment, the
urrent
shadow value of a rm's
apital yields no useful information for investment
be
ause its realized value is always equal to one. Although there is some evi
den
e that this fri
tionless relationship holds in the very long run, e
onomists
have long re
ognized the short
omings of this theory at higher frequen
ies.1
Adjustment
ost models have emerged as the dominant paradigm to ll this
theoreti
al gap. In these models, deviations from the neo
lassi
al
apital equi
librium are the result of an optimizing pro
ess where rms weigh the
osts
and benets of faster adjustment. When adjustment
osts are
onvex, the
pro
ess of
apital adjustment is smooth and the
urrent value of q
ompletely
en
apsulates all of the rm's relevant investment
onsiderations.2 The em
piri
al short
omings of this framework have prompted more re
ent models
that deemphasize q as an investment indi
ator.3 These models emphasize
the lumpiness of investment at the plant and rm levels in the presen
e of
non
onvex adjustment
osts.
However, the
osts of
apital adjustment are not always measured just
in resour
e
osts and lost produ
tionthey may also be re
koned in time.
These lags
ause
ompli
ations for
apital adjustment that are interesting and
1 Caballero [1994℄ shows a long run relationship between the neo
lassi
al user
ost and
the
apital sto
k.
2 Although q is not generally observable, Hayashi [1982℄ demonstrates that, under
ertain
onditions, the
urrent Tobin's Q is an exa
t measure of q.
3 Some well
ited short
oming of the
onvex adjustment
ost model are that (1) invest
ment is too lumpy at the plant and rmlevel to be explained by
onvex adjustment
osts
(Doms and Dunne [1998℄), (2) that
ash
ows seem to
apture some relevant information
for investment by nan
ially
onstrained rms that is not
aptured in Q (Fazzari, Hubbard,
and Peterson [1988℄), and (3) that Q is subje
t to measurement error (Eri
kson and Whited
[2000℄).
1
important in their own right. Be
ause invested
apital be
omes produ
tive
with a delay, rms must base
urrent investment de
isions on fore
asts of
what variables like q and
ash
ow will be when the new
apital
omes on line.
As a result, many of familiar
ontemporaneous linkages between investment, q ,
and the value of the
apital servi
e
ow do not hold after the fa
t. Empiri
al
testing is
ompli
ated by the fa
t that we observe realizations of variables
like Q and
ash
ow rather than the anti
ipated values that are the basis
of investment de
isions. Further, time lags tend to spread out the response
of investment and produ
tive
apa
ity to sho
ks, leading to ri
her dynami
ee
ts.
These building and planning lags have some history in the real business
y
le literature. The seminal work is Kydland and Pres
ott [1982℄, who add a
time to build lag for
apital to a
alibrated RBC model. A more re
ent
ontri
bution by Christiano and Todd [1995℄ adds a planning phase to the Kydland
and Pres
ott setup. These models suggest that
apital gestation requirements
an
apture some empiri
al features of the business
y
le more ee
tively than
standard models with one building period or models with
onvex
apital ad
justment
osts.4 There are also some noteworthy attempts to
onsider ges
tation lags in the investment literature. Majd and Pindy
k [1987℄ explore
the impli
ations of pla
ing a
eiling on the amount of investment that
an
be undertaken ea
h period in the pro
ess of assembling a single (irreversible)
apital proje
t. Investment outlays only
ontinue when the anti
ipated dis
ounted value of the
ompleted proje
t ex
eeds a minimum threshold. Altug
[1993℄ takes a detailed look at
apital pri
ing and investment de
isions in the
presen
e of Kydland and Pres
ott building requirements. She shows that ad
ditions to the
apital sto
k depend on the fore
ast of marginal q after the
building period, whi
h may not be well proxied by the
urrent Tobin's Q.
In the next se
tion of this paper, I develop a model of aggregate investment
in a
ompetitive e
onomy in whi
h rms fa
e distin
t planning and building
lags for new
apital, but no other expli
it adjustment
osts. The e
onomy is
subje
t to temporary and permanent aggregate sho
ks that rms
an distin
guish at the moment they o
ur. These features yield important impli
ations
for investment, the rate of
ash
ow, and Tobin's Q. Investment only responds
to sho
ks that are expe
ted to outlast the gestation horizon, and then only
after the planning phase is
omplete. In
ontrast, both the rate of
ash
ow
and Q respond to all sho
ks throughout their duration,
ovarying positively
4 Christiano and Todd emphasize that a
ombined building and planning lag
an a
ount
for the persistent ee
ts of te
hnologi
al sho
ks, the tenden
y for business and stru
tures
investment to lag movements in output, and the leading relationship of produ
tivity to hours
worked.
2
with asso
iated investment during the building period. As a result, both
ash
ow and Q tend to be noisy indi
ators of investment, where the
orrelation
depends on the relative preponderan
e of temporary and permanent sho
ks
in the data. The model also yields impli
ations for the dynami
response of
investment and produ
tive
apa
ity to sho
ks. The planning phase
auses
a delay in the response of investment spending, while building
auses a lag
between investment spending and the asso
iated in
rease in produ
tion.
Se
tion III performs some empiri
al analysis. First, data for \puried"
Solow residuals are used to show that distin
t planning and building lags
exist, and to estimate their duration. Then, I estimate empiri
al impulse
responses of aggregate investment,
ash
ow, and Tobin's Q to temporary
and permanent sho
ks, and
ompare these responses to the predi
tions of the
gestation lag model and other wellknown alternatives from the investment
literature. These impulse responses are estimated using a stru
tural VAR
that identies temporary and permanent aggregate disturban
es using the zero
frequen
y restri
tions of Shapiro and Watson [1988℄ and Blan
hard and Quah
[1989℄. Among other things, the gestation lag model
orre
tly predi
ts that
aggregate investment is driven almost entirely by permanent sho
ks, while
ash
ow and Q respond to both sho
ks. In addition, aggregate investment exhibits
a delayed response to permanent sho
ks that is
onsistent in
hara
ter to the
model's predi
tions, and in
onsistent with models that have no gestation lag.
Se
tion IV
on
ludes the paper with some dis
ussion of the major results.
II. Model
Let time to plan denote the P periods that begin with the de
ision to add
produ
tive
apital, and end when investment expenditures
ommen
e. Time
to build denotes the B periods that begin with the rst
apital expenditure,
and end when the new
apital be
omes produ
tive. Following Kydland and
Pres
ott [1982℄, assume that a proportion j 2 [0; 1℄ of the planned
apital
addition
PB 1 is a
quired j periods before it be
omes produ
tive
apital, so that
j =0 B j = 1. These lags are depi
ted graphi
ally in Figure 1. At time t,
a rm
ommits to
hange its
apital sto
k at period t + P + B . The P period
planning phase then passes where there are no investment outlays asso
iated
with the plan. At t + P , the building phase begins, with the rm
arrying out
a nonnegative proportion B j of the total expenditure asso
iated with the
plan at ea
h period t + P + j , from j = 0; : : : ; B 1, with B > 0. The new
apital be
omes available for produ
tion at t+P +B , after a total gestation lag
of J = P + B periods.
3
Note that ea
h investment plan is assumed to be irrevo
able in the sense
that the rm
ommits to a spe
i
level of
apital at the end of its gestation
period. This assumption is ne
essary be
ause the planning lag is meaningless
when investment plans
an be
hanged without
ost. More spe
i
ally, the
solution to any intertemporal optimization problem requires a plan for ea
h
ontrol variable for every period in the problem horizon. However, the
ontrol
variables
an be
hanged
ostlessly when the problem is revisited in subsequent
periods, so these plans are not binding. The irrevo
ability assumption makes
this
ost innite for
ommitted plans. Nonetheless, there is no restri
tion that
investment plans be nonnegative, so the irrevo
ability assumption is not the
same as irreversibility. Firms
an plan to dismantle their
apital in subsequent
periods, albeit with the same gestation requirement.
In the remainder of this se
tion, I develop a model for the investment,
ash
ows, and value of an aggregate rm that fa
es the gestation lags des
ribed
above. The rm operates in a
ompetitive small open e
onomy that is subje
t
to temporary and permanent sto
hasti
sho
ks to te
hnology and the supply
of labor. As su
h, all market pri
es are treated as given, and the interest rate
exogenous. The
ompetitive e
onomy assumption is
omparable to Hayashi
[1982℄, whi
h many
ite as a justi
ation for using Tobin's Q as a proxy for
the shadow value of new
apital. Yet unlike Hayashi, the unit of analysis is
an aggregate rm. This is di
tated by the fa
t that the optimal
apital sto
k
of an individual
ompetitive rm is indeterminate when produ
tion exhibits
onstant returns to s
ale, so its optimal rate of investment is not well dened.5
This indetermina
y is not an important issue for the aggregate rm, be
ause
equilibrium in the markets for other variable inputs pins down the aggregate
apital sto
k.6 The fo
us on a small open e
onomy deemphasizes a host of
dynami
general equilibrium
onsiderations that may not be relevant when
the e
onomy is open for trade in
apital and goods. Moreover, this approa
h
allows for a more transparent depi
tion of some issues related to gestation
lags that have been largely negle
ted by previous work, su
h as the role of
temporary
apital s
ar
ity in the investmentQ relationship.
The model development pro
eeds as follows. I begin by spe
ifying the
produ
tion te
hnology for the aggregate rm and nd optimal
losedform so
lutions for the
apital growth rate, the rate of
ash
ow, and Tobin's Q in
a de
entralized equilibrium. Rather than expli
itly solving the de
entralized
5 Although the s
ale of an individual rm in Hayashi's model is also indeterminate, its
rate of investment is pinned down by a rst order
ondition that links q to the marginal
adjustment
ost for
apital.
6 In his textbook, Romer [1996℄ adopts a similar approa
h for his dis
ussion of investment
with adjustment
osts, albeit in redu
ed form.
4
problem to nd these solutions, I employ a number of strategies to simplify
the exposition. Sin
e the de
entralized solution will be eÆ
ient, I obtain the
same optimality
onditions for the produ
tion side by maximizing the value of
an aggregate rm that treats pri
es as given, then imposing that the marginal
produ
t of ea
h input equal its market rental rate. I do not bother to set out
optimal household
onsumption
onditions be
ause these
an be ignored in
the small open e
onomy a
ording to the Fisher separation theorem. Finally,
I in
orporate household labor de
isions in a stylized manner by introdu
ing
a redu
edform aggregate labor supply
urve. The resulting model is used to
des
ribe in detail the interrelationships between
ash
ow, investment, and Q.
I
lose the se
tion by dis
ussing measurement issues that arise from the exis
ten
e of
apital building requirements, and how they ae
t the interpretation
of model results.
1. Cash Flow
For now, ignore the intertemporal aspe
ts of the problem. Let
urrent
output be the numeraire. Assume that the aggregate rm enters the
urrent
period with a predetermined produ
tive
apital sto
k K and level of te
hnol
ogy Z T , and
hooses the quantity of labor L that maximizes variable prots.
Although the impli
ations of the more general CES produ
tion fun
tion will
also be
onsidered, for expositional purposes it is useful (and
onsiderably
more tra
table) to assume the CobbDouglas produ
tion fun
tion
(1) F K; Z T L = K 1 Z T L :
Units of labor
an be hired at the given market wage rate w. After maximizing
out the variable fa
tor L, the aggregate rm's variable prot is
T 1
Z
(2) K j w; Z T ; = (1 ) h K;
w
where is the
orporate tax rate, and h (1 ) 1 . Let the rate of
ash
ow denote the average variable prot of
apital:
T 1
Z
(3) w; Z T ; = (1 ) h :
w
Sin
e total
ash
ows are linear in K , this fun
tion is also the marginal produ
t
of
apital. This equation
an also be interpreted as a fa
tor pri
e possibility
frontier that shows the negative relationship between the labor wage and the
value of
apital servi
es with te
hnology is held xed. Sin
e the CobbDouglas
ase embeds a unit elasti
ity of substitution between
apital and labor the
5
relationship between the fa
tor pri
es is loglinear. In the more general CES
ase, the relationship between the fa
tor pri
es be
omes more
onvex as the
elasti
ity of substitution between
apital and labor diminishes. Therefore,
the value of
apital servi
es will be more sensitive to
hanges in wages and
te
hnology as the degree of
omplementarity de
lines.
Ostensibly, equation (2) suggests that the marginal prot from
apital is
independent of the
apital sto
k, so the aggregate demand for
apital servi
es
seems to be undened. However,
apital demand
an be pinned down by the
aggregate labor market equilibrium. Aggregate labor demand
an be obtained
by applying Shephard's lemma to equation (2), yielding
d K jw; Z T ; w; Z T ;
(4) L = = K:
w 1 w
This fun
tion is in
reasing in the quantities of te
hnology and
apital, and
de
reasing in the real wage and the tax rate. For simpli
ity, assume that the
aggregate labor supply takes the form
(5) Ls = w Z L ;
where 0 is the wageelasti
ity of labor supply, and Z L is a multipli
ative
labor supply sho
k. This formation
an be interpreted as a loglinear approx
imation to the optimization
ondition that will govern aggregate labor supply
in a dynami
general equilibrium model, where the pro
ess Z L is a redu
ed
form fun
tion of (among other things) population and the marginal utility of
wealth. Under this interpretation, the parameter is the Fris
h wage elas
ti
ity of labor supply, and the pro
ess Z L re
e
ts a wide range of permanent
and temporary in
uen
es that emanate from exogenous sho
ks and general
equilibrium adjustment.
The market
learing real wage
an be determined by equating aggregate
labor demand and aggregate labor supply. This wage
an be substituted into
(3) to yield the following equation for
ash
ow as a fun
tion of the aggregate
apital sto
k:
b
Z
(6) (K jZ; ) = h(1 )a
K
where
Z Z T 1+ Z L ;
h (1 )b ;
(1 )( + 1)
a 2 (0; 1); and b 2 (0; ):
(1 ) + 1 (1 ) + 1
6
This fun
tion represents the marginal
ontribution of
apital servi
es to vari
able prots in any given period, or the aggregate inverse demand
urve for
apital servi
es. In a fri
tionless world, this is set equal to the neo
lassi
al
user
ost to determine the
urrent
apital sto
k. The fa
tor Z , whi
h
ombines
both sho
ks to te
hnology and labor supply, neatly en
apsulates the exogenous
(nontax) fa
tors that shift the aggregate demand for
apital servi
es.
The parameter b represents the elasti
ity of
ash
ow with respe
t to the
apital imbalan
e ratio K=Z , after a
ounting for endogenous movements in
labor. In the CobbDouglas
ase, b is bounded in magnitude between zero
and by labor's share . For the more general CES produ
tion fun
tion, b is
inversely related to the elasti
ity of substitution between labor and
apital.
Although a solution of the form in (6) is not generally available when the
produ
tion fun
tion is CES, a loglinear approximation
an be
al
ulated for
the spe
ial
ase where the labor supply elasti
ity is zero. Then the elasti
ity
of
ash
ow with respe
t to
apital imbalan
e in the steady state is shL = ,
where is the
onstant substitution elasti
ity between
apital and labor, and
shL is labor's share of in
ome in the steady state. Intuitively, this indi
ates
that redu
ed substitutability between
apital and variable inputs makes the
value of
apital more sensitive to its degree of aggregate s
ar
ity.
7
sto
k in k periods. Then, the produ
tive
apital sto
k evolves a
ording to
the a
umulation
ondition
(7) Kt+i = Kt+i 1 (1 Æ ) + s1;t+i 1 ;
where Æ is the depre
iation rate. This diers from the standard a
umulation
identity be
ause the addition to the produ
tive sto
k is di
tated by the plan
from J periods earlier rather than
urrent investment. Committed plans evolve
su
h that this period's planned addition at horizon k equals the next period's
plan for horizon k 1, so that
(8) sk 1;t+i+1 = sk;t+i ;
for k =2;: : : ;J . The total investment
ow in ea
h period is the sum of spending
on all
ommitted plans that are in the building pro
ess:
B
X
(9) It+i = j sj;t+i :
j =1
Consequently, the investment
ow is not generally asso
iated with any spe
i
plan; rather, it a moving average of planned additions over the next B periods.
Given this stru
ture, there are many state variables that must be
onsidered
in the optimization problem. At time t, the rm inherits its
urrent produ
tive
apital sto
k, along with planned additions for the next J 1 periods, yielding
a total of J state variables. Note that these plans are relevant to the problem,
although they are not yet part of the produ
tive
apital sto
k, be
ause they
will ae
t the optimal
apital addition at the gestation horizon.
Now
onsider the problem from the perspe
tive of the aggregate rm. For
simpli
ity, the appropriate dis
ount fa
tor is
onstant at R = 1 + r, where r is
the interest rate. New units of
apital
an be pur
hased for a xed pri
e of p,
whi
h is net of the value of any government tax in
entives.7 Sin
e anti
ipated
rates of
ash
ow are
onsidered given, the appropriate notion of variable prot
is K , where represents the fun
tion (3). The market valuation of rm is the
dis
ounted total of all future expe
ted
ash
ows, net of investment outlays
under the optimal plan:
1
X
(10) V (Kt ; fsj;t Jj =11
g jp; ftt+i g1i=0) max R i [t t+i Kt+i pIt+i ℄ ;
fsJ;t+i g1
i=0 i=0
7 This in
ludes both an investment tax
redit and the present value of
apital
onsump
tion allowan
es z . These in
entives ee
tively redu
e the pri
e of new
apital by a fa
tor
(1 z ), where + z is the tax wedge.
8
subje
t to the
onstraints (7) through (9). The rm solves this problem by
planning additions to its
apital sto
k from period t+J onward. However, only
the plan for t+J binds future de
isions.8 Note that t+i is a fun
tion of the given
(but not exogenous) market real wage wt+i , so the valuation problem re
e
ts
expe
ted
onditions in the labor market (and, by impli
ation, the anti
ipated
path of Z )
ontingent on
urrent information.
It is useful to restate this problem as a series of unrelated intratemporal
problems. Tedious manipulation that (among other things) utilizes equations
(7) through (9) to eliminate the
ow variables It+i and sJ;t+i for i> 0 yields:
represent the future value of all the outlays that were ne
essary to a
quire
the
apital at its
urrent stage of
ompletion. For instan
e, to obtain a unit
of
ompleted produ
tive
apital today (i = 0), the rm must pur
hase j
units of new
apital at time t j , whi
h is worth j Rj in today's terms after
ompensating for foregone interest. These payments are summed for j = 1 to
B to obtain the total shadow value q0 . It
an easily be seen that q0 ex
eeds
one. Intuitively, this
ompensates for the interest foregone on
apital outlays
during the unprodu
tive building period. Also, note that the
apital outlays
8 Equation (10)
an be amended to in
orporate the personal taxes and depre
iation al
lowan
es the rm holds for its existing
apital. Let t and t represent the tax rates on
g d
apital gains and dividends, respe
tively, and let Z~ represent the present value of the re
t
maining
apital
onsumption allowan
es on the rm's existing
apital. Then, the value of
R 1 d
the rm be
omes V~ = ( g ) (V + Z~ ), where R = 1 + 1 g in (10).
t r
R t t t
9
asso
iated with a given plan do not ae
t the value of the rm until the outlay
has taken pla
e.
The third set of terms in (11)
aptures the value of the quasirents that
the rm expe
ts to earn on its produ
tive
apital during the gestation period.
These anti
ipated rents o
ur be
ause the rm
annot adjust its produ
tive
apital to re
e
t new information until the end of the gestation horizon. The
rent in ea
h period is the dieren
e between the
ash
ow (re
koned in terms
of
apital) and the steady state user
ost of
apital u , multiplied by the
a
quisition value of the
apital. The steady state user
ost is given by
(13) u q0 (1 Æ )R 1 q0 ;
whi
h represents the total opportunity
ost of obtaining a unit of
apital ser
vi
es for the
urrent period only. This is the steady state value of a unit of
produ
tive
apital q0 today less pro
eeds that
ould be obtained from selling
the undepre
iated portion of the installed
apital next period.
The nal set of terms in (11) represents the value of the quasirents that
the rm expe
ts to earn from the
urrent gestation horizon onward. At this
point, it is useful to temporarily
onsider the problem from the so
ial planner's
perspe
tive. From this viewpoint, it is optimal for these anti
ipated rents to
be zero so that the marginal so
ial
ost of
apital is equal to its marginal
so
ial benet. This requires the steady state user
ost of
apital to equal the
anti
ipated
ash
ow from the gestation horizon onward, so that
t
t+J +i
(14) = u for all i 0:
p
This implies that
ash
ow is always expe
ted to return to its long run ben
h
mark of u at the end of the gestation horizon. The rm's optimal plans must
be
onsistent with this anti
ipated market equilibrium, so this
ondition ee

tively pins down the path of
ash
ows (and, in turn, produ
tive
apital) from
the gestation horizon onward. Consequently, the nal set of terms in (11) are
always zero, so they drop out of the problem.
Condition (14)
an be used to determine the equilibrium aggregate
ap
ital sto
k for period t + J and nonbinding plans for the aggregate sto
k in
subsequent periods. Using equations (6) and (14), one
an determine that:
1
h(1 )a b
(15) Kt+J = Et [Ztb+J ℄ b :
1
pu
Note that the quantity of
apital is based upon a fore
ast of Z , rather than
its realization. Therefore, the
apital sto
k
an only respond to unanti
ipated
10
movements in the fa
tor Z with a lag. Moreover, transitory movements in
Z that are not expe
ted to outlast the gestation horizon will never ae
t the
apital sto
k. Despite this, the
apital sto
k does move roughly in proportion
with the demand for
apital servi
es in the long run.9
These statements
an be established formally by assuming that the
apital
demand fa
tor Zt follows an exogenous pro
ess. For simpli
ity, I approximate
a niteorder ARIMA using the IMA form
(16) ln Zt+1 = ln Zt + + (L) t+1 + (L)t+1 ;
where t+s and t+s , are normally distributed iid sho
ks with zero mean and
unit varian
e. The parameter is (approximately) the expe
ted rate of growth
in the level of fri
tionless
apital demand. (L) and (L) are the following
polynomials in the lag operator L:
nT
X nG
X
(17) (L) i Li ; and (L)
i Li ;
i=0 i=0
where nT is a positive integer, and nG is a nonnegative integer. It is assumed
that there is a unit root in the MA polynomial , whi
h ensures that only the
1 10
t sho
ks have a permanent ee
t upon the sequen
e fZt+s gs=0 .
Now
onsider the rate of growth in the
apital sto
k, given the exogenous
pro
ess for Z des
ribed above. Although it need not be generally true, assume
for expositional purposes that (L) =
0 =
, so that the permanent portion
of Z is a random walk. Let gtK = ln Kt denote the growth rate in the
apital
sto
k at t, where is the rstdieren
e operator 1 L. By equation (15), this
growth rate is
1
(18) gtK+J = ln Et [Ztb+J ℄ ln Et 1 [Ztb+J 1 ℄ :
b
Substituting the
onditional expe
tations of Ztb+j for j = J and j = J 1 into
this equation yields
min(XJ;nT ) min(X
nT J;0)
K
gt+J = +
t + t i + J +i t i :
i=0 i=1
The growth rate in produ
tive
apital at t + J is equal to the un
onditional
growth rate , plus adjustments for the anti
ipated ee
t of sho
ks dated t
9 Note that by Jensen's inequality, E [Z + ℄ 1b < E [Z + ℄, so E [K ℄ 6 E [Z ℄.
b
10 Further, assume that the
umulative sum of the M A
oeÆ
ients in (L) and (L) are
t t J t t J t t
never negative up to any lag. This ensures that the
umulative ee
t of ea
h sho
k is always
in one dire
tion.
11
and earlier on the rate of growth in the
apital demand fa
tor Z . The dynami
ee
ts of these sho
ks are summarized by the impulse responses
8 8
<0
> j<J j<J
<0
>
gtK+j gtK+j
= Pi min( J;n)
i j=J and =
j=J :
t >
:
=0
t > :
j j>J 0 j>J
Sho
ks never ae
t produ
tive
apital growth until the end of the gestation
horizon J , be
ause they were not observable when the
apital plans were
om
mitted. At the gestation horizon (j = J ),
apital growth generally has a large
at
hup response to the anti
ipated
umulative ee
t of the sho
k on the de
mand for
apital servi
es. For a permanent sho
k, the response of produ
tive
apital growth is
onned to horizon J . No further adjustment is required at
subsequent horizons, be
ause the extra demand for
apital is fully re
e
ted
in the
apital sto
k. In
omparison, a temporary sho
k may not ae
t the
growth rate of
apital at all if it is suÆ
iently shortlived (so that nT < J ).
More generally, a temporary sho
k will prompt produ
tive
apital growth at
horizon J if it outlasts the gestation horizon. However, this will eventually
be a
ompanied by negative
apital growth in subsequent periods, sin
e the
temporary sho
k has no ee
t on the fri
tionless demand for
apital servi
es
in the long run.11 As the length of the gestation horizon in
reases, it be
omes
in
reasingly unlikely that temporary sho
ks will outlast the gestation horizon
and prompt investment. Provided that the gestation horizon is suÆ
iently
long,
apital growth will only be asso
iated with permanent sho
ks.
In this se
tion I
onsider the relationship between the growth rate in pro
du
tive
apital and two variables that are
ommonly used as indi
ators for
investment, the rate of
ash
ow and Tobin's Q.
By equation (14), the rate of
ash
ow is always expe
ted to return to the
steady state user
ost at the end of the
urrent gestation horizon. Despite
this, the realized demand for
apital servi
es at this long run user
ost will
not generally be equal to the xed
ow of
apital servi
es available to the rm
in any given period. This is be
ause the quantity of produ
tive
apital was
determined J periods earlier, using in
omplete information. As a result, the
11 This fa
t
an be demonstrated as follows:
ln Kt+j X
j
gtK+i
min(X T )
j;n
lim
j !1
= lim
!1 =1 = lim
!1 i = (1) = 0:
t j
i
t j
i =0
12
shadow value of
apital servi
es adjusts to equal the true e
onomi
value of
apital after the fa
t. This
an be demonstrated by using equations (6) and
(14) to yield
t Ztb
(19) = u:
p Et J Ztb
The realized
ash
ow does not generally equal the long run user
ost be
ause
of errors in fore
asting the
apital demand fa
tor Z . If this expe
tational error
is positive, the demand for
apital servi
es at the long run user
ost ex
eeds
the
apital sto
k, so the rate of
ash
ow rises to re
e
t the relative s
ar
ity
of
apital. If the expe
tational error is negative, there is a surplus of
apital
relative to the demand for
apital servi
es at the long run user
ost, so the
rate of
ash
ow de
lines.
Indeed, on
e the
apital sto
k has been established for any given period, the
shadow user
ost of
apital must adjust to equilibrate the demand for
apital
servi
es with the xed supply.12 To a
omplish this, the anti
ipated shadow
value of
apital adjusts to satisfy the Euler
ondition
t t+j
(20) = t q0;t+j (1 Æ )R 1 t q0;t+j +1 ;
p
for all 0 j <J , where q0;t+j is the shadow value of produ
tive
apital at t+j .13
Intuitively, this ex ante shadow user
ost represents the internal
ost to the
rm of foregoing one unit of
apital servi
es in period t + j : the anti
ipated
shadow value of produ
tive
apital at t + j less the shadow value of a unit of
produ
tive
apital in the following period after depre
iation. Figure 2 shows
a graphi
al depi
tion of this pro
ess. At period t, the
apital sto
k for t + J
is determined by the interse
tion of the demand and supply
urves for
apital
servi
es. Demand is equal to the
ash
ow at ea
h K ,
onditional on
urrent
expe
tations for Z . Supply is perfe
tly elasti
at the long run user
ost. This
initial de
ision xes the supply of
apital servi
es at t + J . An unanti
ipated
in
rease in
apital demand at t + J in
reases the demand for
apital servi
es
at ea
h user
ost. Hen
e, the anti
ipated shadow user
ost must rise to u0 to
equilibrate anti
ipated demand with supply. To satisfy (20), the anti
ipated
shadow user
ost at t+J must rise relative to its value in the following period.
Intuitively,
ash
ow responds immediately to all fore
ast errors in Z , re
gardless of the duration of the disturban
e. The sho
k will
ontinue to ae
t
12 The
on
ept of an ex post shadow pri
e of
apital (or temporary equilibrium with
apital
xity) has been explored by Berndt and Fuss [1986℄ and Hulten [1986℄.
13 This
an be
al
ulated using the envelope theorem, by putting (10) in an iterative
(Bellman) form, then
al
ulating the partial derivative q0 V =p. The result for periods
;t K
13
the rate of
ash
ow until the
apital sto
k has had a
han
e to fully adjust to
the additional
apital demand. This
an be established formally by using the
exogenous pro
ess for Z in (16) and equation (19) to
al
ulate the following
impulse responses for temporary and permanent sho
ks:
ln t+j
(
P
b i min( j;n)
i 0j<J ln t+j
(
b
0 j < J
= =0
; and = :
t 0 otherwise t 0 otherwise
Generally, the ee
t of any sho
k on
ash
ow depends on the magnitude of
the sho
k and the elasti
ity fa
tor b. At impa
t, a sho
k raises
ash
ow by the
produ
t of b and the impa
t MA
oeÆ
ient. To the extent that it persists, a
sho
k
an ae
t future
ash
ows up to the gestation horizon. For a horizon of
j periods after the sho
k, the ee
t depends on the
umulative sum of the MA
oeÆ
ients up to lag j . Intuitively, this sum represents the
umulative ee
t
of the sho
k on the fore
ast error for Z b . Neither temporary nor permanent
sho
ks ae
t
ash
ow at the gestation horizon or beyond, on
e
apital has the
ability to adjust. The ex post rents
aused by sho
ks are always unanti
ipated
and transitory, as one would expe
t in a
ompetitive market.
The degree of
omovement between the rate of
ash
ow and investment
depends on the nature of the sho
k. For permanent sho
ks, the
omovement
is positive. Cash
ow responds to the sho
k immediately, and
ontinues to be
ae
ted to the end of the gestation horizon. Although growth in the produ

tive
apital sto
k is postponed to the gestation horizon and beyond, invest
ment spending
ommen
es at the planning horizon P . Therefore, both
ash
ow and investment respond in the same dire
tion during the building period.
Temporary sho
ks with a duration shorter than the gestation horizon do not
prompt investment, so there is no positive
omovement. Temporary sho
ks
that outlast the gestation horizon may
ause investment to
omove positively
or negatively with
ash
ow. In order for a temporary sho
k to ae
t
apital
growth, it must also ae
t
ash
ow up to the end of the gestation horizon, in
the same dire
tion as the sho
k. If this is the
ase, the investment response at
the building horizon is in the same dire
tion as
ash
ow. However, sin
e the
temporary sho
k
annot ae
t the level of the
apital sto
k in the long run,
the positive initial response of investment must eventually be reversed with
negative investment. Some of this negative investment may o
ur while
ash
ow remains elevated within the building phase. Nonetheless, it is reasonable
to expe
t the
orrelation between investment and
ash
ow to be positive,
on balan
e, with the strength of the
orrelation depending on the relative
preponderan
e of temporary and permanent sho
ks in the e
onomy.
Tobin's Q is usually
al
ulated as the
urrent market value of a rm divided
by the repla
ement value of its
urrent
apital sto
k. For now, assume that
14
the repla
ement value of
apital is measured as the repla
ement value of the
produ
tive
apital sto
k. Then (11)
an be used to determine that
X1 si;t J 1
B
X K
(21)
Q t = q0 +
qi + R t t+i
i u t+i :
i=1
Kt i=0
p Kt
The rst two terms in (21) represent the value of the funds
ommitted to
produ
tive
apital and ongoing building eorts, per unit of produ
tive
apital.
The un
onditional value of these two terms generally ex
eeds one, for two
reasons. As demonstrated earlier, the un
onditional shadow values in
orporate
ompensation for foregone interest during the gestation period. As well, the
planned
apital additions si;t are generally positive owing to e
onomi
growth.
Therefore, when there are gestation lags, this measure of Q should ex
eed one
in the long run. The nal term shows that Q re
e
ts the anti
ipated value of
e
onomi
rents looking forward over the entire gestation horizon.
Sin
e Q re
e
ts both the value of produ
tive
apital and of
ommitted
plans, it is not equivalent to the shadow value of produ
tive
apital q0;t . In
Appendix A, I demonstrate that
J 1
X si;t
(22) Qt = q0;t + qi;t ;
i=1
Kt
where qi;t is the
urrent shadow value of si;t . Further, I show that the shadow
value of produ
tive
apital is its steady state value, plus the dis
ounted value
of all anti
ipated rents during the gestation period:
J 1 j
X R t t+j
(23) q0;t = q0 + u ;
j =0
1 Æ p
where the dis
ount fa
tor in
ludes (1 Æ ) in order to
ompensate for the
opportunity
ost of depre
iation. This
onrms that both q and Q re
e
t the
same e
onomi
rents that ae
t
ash
ow. As ltrations of the same sho
k
pro
ess they provide similar e
onomi
information.
Moreover, neither Qt nor q0;t
onsistently provide reliable information about
urrent investment. Re
all that the
apital sto
k is determined by equating
the anti
ipated demand for
apital servi
es to the long run user
ost of
apital
u . This
orresponds to setting t q0;t+J equal to the xed long run shadow value
q0 . Consequently, the deviation between the realization of q0;t+J and q0 is a
fore
ast error that must be orthogonal to produ
tive
apital growth at t + J .
However,
urrent values of Qt and q0;t
omove with investment to the extent
15
that sho
ks to Z
reate unanti
ipated rents during the building phase of the
gestation period. In addition, there will be a response in Q owing to the dire
t
ee
t of investment expenditures on the value of the rm during the building
pro
ess. Intuitively, a permanent sho
k to Z ae
ts Qt (and q0;t ) on impa
t, by
ausing anti
ipated rents during the entire gestation horizon. Both variables
respond in the dire
tion of the sho
k throughout the gestation period be
ause
rents persist over time. At the planning horizon, investment expenditures
begin to respond to the sho
k. Therefore, both Qt and q0;t
ovary positively
with investment during the building pro
ess. However, as with
ash
ow, this
omovement breaks down for temporary sho
ks that are not suÆ
iently long
lived to prompt investment. When this is the
ase, movements in Qt (and q0;t )
are unrelated to investment.
These
laims
an be
onrmed formally using impulse responses for the
loglinearized value of Qt . Using the loglinearization in Appendix B, the
impulse responses
an be
al
ulated using the responses for
ash
ow and
apital growth, yielding
1 j
ln Qt+j BX1 gtK+j +i JX ln t+j +i
t
i
t
+ !i
t
i=1
8 i=0
J 1 j
>b
P !
>
> 0jP
>
> i
< i=0
=
+ b
J P 1 j
>
> J j !i P < j < J 1 ; and
>
>
> i=0
:0 jJ
1 j
ln Qt+j BX1 gtK+j +i JX ln t+j +i
t
i
t
+ !i
t
i=1 i=0
8
JP1 j min( Pj;n)
>
>
>
> ! i b i 0jP
< i=0
> i=0
= J j P i + P J j k J k + P !i b P i P < j < J 1 :
min( J;n
) max( j P ;1 0) J j
1 j;n
min( )
+ +
>
> i k i i
BP1
=0 =1 =0 =0
>
>
>
: k j +k jJ
k=1
16
eventually de
line as a new long equilibrium be
omes imminent, be
ause the
horizon over whi
h they o
ur be
omes smaller. However, this ee
t need
not be strongest on impa
t. If the sho
k has suÆ
ient duration to prompt
investment, there is a se
ond phase in whi
h Q rises to re
e
t the value of
nonprodu
tive
apital as it is a
umulated throughout the building phase.
This ee
t be
omes stronger as the new long run equilibrium approa
hes. Fi
nally, a third phase may arise for temporary sho
ks that outlast the gestation
horizon. In this phase, the
apital sto
k
ontinues to adjust downward as the
sho
k dies out over time. In this phase, there are no rents, but Q de
lines to
re
e
t the value of ongoing disinvestment.
17
B = 1 and 1 = 1.15 In this general
ase, the a
ounting measure K~ t+1 is a
weighted average of the planned sto
ks of produ
tive
apital from t+1 to t+B ,
with the weight at horizon j equal to the spending proportion B j . Provided
that there is a building period, the a
ounting measure in
orporates
hanges
in the produ
tive
apital sto
k before they o
ur.
It is also useful to determine a mapping from the a
ounting measure of
apital growth to the true produ
tive measure. Dene g~tK+i as the rate of
growth in a
ounting
apital, ln K~ t+i . The appendix shows that this maps
to the true produ
tive measure by the lag polynomial
B
X
(25) g~tK+1+i ~(L)gtK+B+i ; where ~(L) = ~B j Lj ;
j =0
and ~(1) = 1. Again, this generalizes the standard
ondition, whi
h
orre
tly
measures produ
tive
apital in the spe
ial
ase where J = B = 1. The growth
rate in the statisti
al measure is approximately a weighted average of the
growth rates in the produ
tive
apital sto
k over the next B periods. The
weights ~j are
losely related to the true spending weights j .16
The responses des
ribed earlier in this se
tion
an be translated to
ases
where
apital is measured using the standard a
ounting. A
ounting
apital
growth never re
e
ts sho
ks until the planning horizon is
omplete. Thereafter,
a planned addition to produ
tive
apital works its way through the building
phase, ae
ting the observed measure of
apital growth by the amount that it
hanges spending in ea
h period. This
an be seen using the equations
8
<0
> jP
g~tK+j ~J j +1 gtK+J
t
>
t
J >j>P ; and
:
0 j>J
8
g~tK+j <0
> jP
>min(j PP;B 1) gK :
t : ~B i t+B+tj i 1
j>P
i=0
These responses show that the measured
apital growth asso
iated with any
plan is spread throughout the building period. For example,
onsider a per
manent sho
k t that in
reases gtK+J by one per
entage point. Due to the
15 Note that this also embeds a spe
ial
ase where there is no time to build, so 0 = 1. For
this
ase, the endoftheperiod statisti
al measure, after
urrent investment, is the a
tual
quantity of produ
tive
apital during the period.
16 The weights ~ give slightly more importan
e to spending at longer horizons j than ,
j j
18
planning lag, the sho
k doesn't ae
t observed
apital growth up to t + P +1.
During the building phase, the sho
k ae
ts observed
apital growth by ~j
per
entage points in ea
h period, where j is the number of periods to the end
of the gestation horizon. On
e the building period is
omplete, there are no
further ee
ts on observed
apital growth.
Sin
e K~ t is used to
al
ulate measures of
ash
ow and Q, dis
repan
ies
between produ
tive
apital and the a
ounting measure also ae
t how these
variables respond to sho
ks. The a
ounting measures of
ash
ow and Q are
related to their true produ
tive measures by
K~ t+i K~ t+i
(26) ln ~t+i = ln t+i ln and ln Q~ t+i = ln Qt+i ln :
Kt+i Kt+i
Applying a linear approximation yields that
K~ X1
B
(27) d ln t+i (
~ L)dgtK+B+i ; where ~ L) =
( ~ B j Lj ;
Kt+i j =0
and ~ B j = ~B + : : : + ~j . Therefore, the
hange in the \error" asso
iated
with mismeasurement of the
apital sto
k is related to a distributed lag of the
growth rates in produ
tive
apital over the building horizon.
This measurement dis
repan
y ae
ts the interpretation of the impulse re
sponses for
ash
ow and Q as follows. Up to the end of the planning horizon
P , the error has no ee
t. Intuitively, this is be
ause the a
ounting measure
of the
apital sto
k has not yet rea
ted to the sho
k. If the sho
k has suÆ
ient
duration to prompt investment, the a
ounting measure of the
apital sto
k
rises over the
ourse of the building period. Therefore, it has a progressively
negative in
uen
e on the impulse response. If b is below one, this ee
t eventu
ally be
omes strong enough to outweigh the positive in
uen
e of rents on
ash
ow and Q, so the response be
omes negative at suÆ
iently long horizons.
1. Data
19
the Bureau of E
onomi
Analysis (BEA), the Bureau of Labor Statisti
s (BLS),
and Data Resour
es International (DRI). The a
ounting measure of the
ap
ital sto
k was generated iteratively using quarterly xed investment expendi
tures and a one period timetobuild
apital a
umulation identity.17 Following
Hall [2001℄, I
al
ulate the measure of the aggregate market value of physi
al
apital as the value of equity and debt, less the value of all non
apital assets
(in
luding liquid assets), residential stru
tures, and inventories. Both Tobin's
Q and
ash
ows are adjusted to a
ount for
orporate in
ome taxes and the
in
uen
e of investment tax
redits and depre
iation allowan
es on the ee

tive pri
e of
apital. A detailed des
ription of the data
onstru
tion is given
in Appendix F.
Time plots of the data are shown in Figures 3 to 5. Table 1
ontains sample
moments. Figure 3 demonstrates the
onsiderable volatility in
apital growth,
whi
h exhibits many prolonged movements around a mean of about 1.1 per
ent
per quarter. Cash
ows and Tobin's Q are plotted in Figures 4 and 5, respe

tively. Sin
e the tax
orre
tion for the pri
e of
apital goods de
reases the
repla
ement value of the a
ounting measure of
apital, it
auses a noti
eable
in
rease in both series. The measure of Q is very volatile, and does not seem
to revert to a dis
ernable long run level. Rather, the series is
hara
terized by
its many highfrequen
y movements around prolonged, lowfrequen
y trends.
Note from Table 1 that the sample average of the tax
orre
ted measure is
well above one, whi
h is
onsistent with the gestation model for
apital. Cash
ow seems to
y
le around a stable long run mean, with movements resem
bling the business
y
le. Although there are periods where
ash
ow and Q
exhibit
oheren
e with investment, neither is a
onsistent indi
ator. Despite
this, the three variables have positive mutual
orrelation, whi
h is apparent
by inspe
tion of the plots.
Visually, it appears that the Q series may be nonstationary. Table 2 ex
plores this possibility using the Augmented Di
key Fuller test and the Varian
e
Ratio test. The Di
key Fuller test reje
ts a unit root in g~tK and ~t , but fails to
reje
t for Q~ t . This is problemati
for most investment theories, sin
e Q should
revert to a welldened long run level. Inspe
tion of Figure 5 suggests that
this failure may re
e
t very lowfrequen
y movements in the level of Q, whi
h
ould be explained by a number of fa
tors, in
luding, for example,
hanges
in the ee
tive tax rate on
apital gains and dividends, or
hanges in
ompo
nents of rm value that are outside of the model, su
h as intangible
apital
17 A presample for the
apital sto
k was generated for the period 1947Q1 to 1959Q1 in
order to minimize the possibility of errors asso
iated with an appropriate starting value.
The initial value for the end of 1946 was set equal to the BEA's estimate of the real
apital
sto
k.
20
(Hall [2001℄).18 Varian
e ratios for Q diminish
onsiderably at longer horizons,
whi
h provides eviden
e against a unit root.
In this se
tion, I use tests involving Solow residuals and labor hours growth
to
onsider two distin
t issues. The rst issue is whether there is a delayed
response of investment to aggregate sho
ks, whi
h I interpret as a planning
lag. The se
ond issue is whether there is a delayed response of produ
tive
apital to investment, whi
h would be asso
iated with a building lag.
John Fernald kindly provided quarterly Solow residuals for the period 1965Q2
to 2001Q4 that are
orre
ted for measurement errors owing to
hanges in labor
quality and variable fa
tor utilization using the methodology in Basu, Fernald,
and Shapiro [2000℄.19 The Solow residuals are divided by a labor share of
= 2=3 to
onvert to units of laboraugmenting te
hnologi
al progress. Quar
terly data for aggregate labor hours of nonnan
ial
orporations are from the
BLS. Figure 7 shows a time plot of the puried Solow residuals and the growth
rate in aggregate labor hours.
There have been a few attempts to measure the duration of the gestation
period using
ase studies at the plant and rm level, and other nonparametri
methods. Estimates by Koeva [2000℄, Mayer [1960℄ and Krainer [1968℄ sug
gest that the
apital gestation lag ranges between one and two years. Mayer
[1960℄ and Jorgenson and Stephenson [1967℄ obtain estimates of the planning
duration ranging between six months and a year.20
ii. Planning
21
In the fri
tionless neo
lassi
al model, investment should respond to the sho
k
immediately, with the maximum rate of response at impa
t. In a model with
onvex adjustment
osts, the investment response is also largest on impa
t,
but is more drawn out over time. Models with xed adjustment
osts, su
h as
Caballero and Engel [1999℄, and irreversibility, su
h as Abel and Eberly [1993℄,
tie the likelihood of investment to the degree of departure from the fri
tionless
demand for
apital servi
es. Provided that the sho
k is not too large, generally
some rms will invest, and some will not. This implies that aggregate
apital
growth depends on the distribution of the
apital imbalan
es for all rms in the
e
onomy. Sin
e some rms are prompted to invest in response to an aggregate
sho
k, neither of these issues
ompli
ate the initial timing of the aggregate
response, only the magnitude. To get the maximum benet, most rms that
do adjust should do so immediately.21
To investigate whether there is a planning lag in response to te
hnology
sho
ks, I estimated the following equation using OLS:
nsr
X
(28) g~tK+1 =
0 + di sr
~ t i + e1t ;
i=0
where sr
~ t i is the puried Solow residual at lag i. To
onserve degrees of free
dom, I
hose a maximum lag length of 14 quarters, whi
h seems a reasonable
bound for the total gestation horizon given the previous resear
h dis
ussed
above. This spe
i
ation nests all possible planning and building
ombina
tions as spe
ial
ases. Given the generalized form of the growth rate in the
a
ounting measure of
apital in (25),
B
dg~tK+1 X
~ dgtK+B j
(29) = = dP +i ; for i = 0; : : : ; B:
~ t P i j =0 B j dsr
dsr ~t P i
Most investment models make the impli
it assumption that P = 0 and that
either ~0 = 1 or ~1 = 1. Sin
e these models suggest an immediate response
of produ
tive
apital growth at the building horizon, d0 should be positive. If
there is a planning lag, dP should be the rst positive
oeÆ
ient, and P should
be an estimate of the planning horizon.
The magnitude of the estimated
oeÆ
ients
an be given a stru
tural inter
pretation in the gestation lag model for a spe
ial
ase where te
hnology and
labor supply disturban
es are un
orrelated, and the te
hnology pro
ess is a
21 Although it is possible that some rms might rea
h their investment trigger faster in
the following periods (due to depre
iation), it seems doubtful that this ee
t would
ompose
most of the response.
22
random walk. For this
ase, the results of Appendix D show that
dP +i = ~B i (1 + ) :
Empiri
al estimates of the wageelasti
ity of aggregate labor supply range
between 0 and 1. For the spe
ial
ase where = 0, the
oeÆ
ient dP +i should
be a dire
t estimate of the spending share ~B i .
Results for this regression are shown in Table 3. CoeÆ
ient estimates are
insigni
ant up to the fourth lag, whi
h is signi
ant at ten per
ent. This
suggests a planning period for investment of one year, whi
h is at the high
end of previous estimates by Mayer [1960℄ and Jorgenson and Stephenson
[1967℄. Thereafter, the
oeÆ
ients for lags ve through ten are ea
h signi
ant
at levels of ve per
ent or lower. This suggests a planning lag of four or
ve quarters. The magnitude of the
oeÆ
ients at lags four through seven
indi
ate that about 13 per
ent of the investment expenditures asso
iated with
a given plan o
ur during this time window. If the tenth lag is interpreted
as the end of the building horizon, the estimates suggest a total gestation
period of ten quarters, with a building phase from period four to period ten.
However, this interpretation is subje
t some important
aveats. In prin
iple,
the building period should be measured by the delay between the initial
hange
in investment spending and the time it begins to ae
t produ
tive
apital.
Sin
e it is possible for building to
ontinue with little or no expenditures, this
may not a
urately re
e
t the length of the building horizon. A se
ond
on
ern
with this interpretation is that the signi
an
e of the lagged
oeÆ
ients beyond
the initial planning stage may re
e
t a planning period
ombined with
onvex
adjustment
osts for
apital and/or prolonged general equilibrium adjustment.
In the absen
e of labor supply endogeneity, the
oeÆ
ients di , i = P; : : : ; J
should sum to one over the building period. The tests reported in the bottom
portion of Table 3 show that the
umulative sum of the
oeÆ
ients up to the
tenth lag is about one fourth, falling well short of the required ben
hmark in
terms of magnitude and signi
an
e. Among other things, this failure may
re
e
t in
onsisten
y in the regression estimates owing to measurement error
or endogeneity. Another plausible explanation is the presen
e of external ad
justment
osts in general equilibrium. In dynami
general equilibrium models
that exhibit the balan
ed growth property, it is well known that permanent
te
hnology sho
ks prompt an equivalent
umulative response in
apital growth.
However, due to the smoothing of
onsumption and labor, the response will
tend to be drawn out over time even in the absen
e of internal adjustment
osts
and/or
apital gestation lags. Reasonably
alibrated RBC models suggest that
it takes the e
onomy between three to six quarters to
omplete onefourth of
the total
apital growth mandated by a permanent te
hnology sho
k. In the
23
ben
hmark
ase of Campbell [1994℄, whi
h features CobbDouglas produ
tion,
xed labor, and unit intertemporal substitution elasti
ity, the e
onomy takes
about seven quarters to
omplete onefourth of the mandated
apital growth.22
Indeed, this smoothing ee
t be
omes more pronoun
ed as the duration
of the gestation period in
reases. Figure 9 shows the response of measured
apital growth to a permanent te
hnology sho
k in a
alibrated RBC model, for
building lags ranging from one to nine quarters. In ea
h
ase, it is assumed that
expenditures are distributed evenly throughout the building period. Details
of the model setup and
alibration are outlined in Appendix E. A
ording
to these simulations, the time required to
omplete one fourth of the total
adjustment in
reases exponentially with the building horizon, rising from seven
quarters with TTB=1, thirteen quarters with TTB=5, to 104 quarters with
TTB=9. Given these results, the magnitude of the estimated
oeÆ
ients are
not unreasonable, nor is the notion that they
ould be a reasonable out
ome
for an e
onomy without expli
it internal adjustment
osts for
apital.
The regression results provide eviden
e for a substantial planning lag. Not
only is there a delayed response of investment to sho
ks, but the
umulative
response up to the third lag is not signi
antly dierent from zero. As well,
the
hara
ter of the response is in
onsistent with other models. The response
is a
tually humpshaped, peaking at the seventh lag. Most models without
planning would tend to have the largest response on impa
t, or, most favorably,
a
at response out to some horizon. The estimated response is in
onsistent
with these possibilities. To wit, the estimated
umulative response from the
fourth lag to the third lag is statisti
ally larger than the estimated
umulative
response from impa
t to the third lag. Although these fa
ts are
hallenging to
other models, they
an easily be re
on
iled with planning and building lags.
iii. Building
24
measure of the growth rate in produ
tive
apital and te
hnology:
(30) ~ t g~tY
m g~tH = (1 )gtK + srt ;
where g~tY and g~tH are the measured growth rates in output and labor, and srt
is true te
hnologi
al growth. This suggests a stru
tural equation of the form:
(31) m~t = sr + (1 )gtK + sr;t
25
at su
essive lags. Although the
oeÆ
ients attenuate in magnitude at larger
lags, it is highly plausible that estimates would yield signi
ant
oeÆ
ients
for j B . Therefore, the highest lag with a signi
ant
oeÆ
ient
annot
be interpreted as an estimate of the building horizon. As a further example,
onsider a
ase where B = 2 but ~2 =1/3 and ~1 =2/3. In this
ase, the root
~ L) is unstable at 0.5, and the mapping is
of the lag polynomial (
1 j
3X 1
gtK = g~tK+j :
2 j =0 2
The suggested regression would have a signi
ant impa
t
oeÆ
ient, but no
signi
ant
oeÆ
ients at any other lag. The results would in
orre
tly point to
a one period building horizon.
A less problemati
stru
tural spe
i
ation
an be obtained by
ombining
equations (25) and (31) to obtain the following spe
i
ation:
B
X
(32) g~tK+1 = b0 + bj m
~ t+j + et ; where
j =1
B
sr X ~j ~ ~j
b0 ; et sr;t+j ; and bj
1 j =1
1 1
for j = 1;: : : ;B . Here, observed
apital growth depends on forward values
of the impli
it measure of
apital growth and the te
hnology disturban
e. By
onstru
tion, the impli
it measure m~ t is negatively
orrelated to the error term
be
ause it
ontains the te
hnology sho
k sr . However, potential endogeneity
problems
an be avoided by instrumenting for the forward values of m ~ t+j .
Finding an appropriate set of instruments is a thorny issue. First, the re
gression requires a lot of instruments. To avoid in
onsisten
y, the number
of in
luded leads of m~ t should be no smaller than the building lag. To sat
isfy the order
ondition, at least one instrument must be in
luded for ea
h
lead. Se
ond, although the set of valid instruments
ontains the entire time
t information set, most
hoi
es are likely to have limited strength be
ause
the variation in ea
h regressor is partially attributable to an unfore
astable
te
hnology sho
k. Nonetheless, some su
ess was a
hieved using
urrent and
lagged values of the measured growth rates in
apital and labor hours. These
hoi
es were motivated by theoreti
al
onsiderations. In order to identify all
the spending shares ~j , information about the growth rates in the produ
tive
apital sto
k from t +1 to t + B must be in
luded. Provided that te
hnology
sho
ks are exogenous, serially un
orrelated, and unfore
astable, anything in
the time t information set is un
orrelated to et . A
ording to equation (25),
26
measured
apital growth at t re
e
ts the growth rate in produ
tive
apital
from t to t + B 1, while lags up to t + B 1
ontain additional identifying
information. However, these measures provide no information on gtK+B , leav
ing ~T +B unidentied. Under the model, planned additions to the produ
tive
apital sto
k re
e
t information on labor growth from J periods earlier. Pro
vided that P > 0, labor growth from periods t to t J +1 should
ontain the
needed information, plus overidentifying information about the growth rates
from t +1 to t + B 1.
Unfortunately, the estimates using this spe
i
ation are likely to suer from
a signi
ant small sample bias. This is be
ause the redu
edform disturban
es
et are auto
orrelated at lags up to B 1, whi
h violates the GaussMarkov
assumptions. Therefore, tests that rely on asymptoti
distributions will give
misleading results. To
orre
t for this problem, I generate bias
orre
ted
on
den
e intervals for the estimated parameters, using a bootstrap te
hnique.25
The results of the regression are shown in Table 4. The set of explanatory
variables
ontains twelve forward values of the m ~ t+j , whi
h are instrumented
using measured rates of growth in
apital and labor hours for lags ranging
from zero to thirteen quarters. After
orre
ting for smallsample bias using
a bootstrap, the estimated
oeÆ
ients are statisti
ally signi
ant at leads +2
and from +4 through +8 at signi
an
e levels of ten per
ent or higher.26 The
estimates at the remaining leads are not dierent from zero at signi
an
e
levels of at least ten per
ent. This
ould indi
ate a la
k of power against the
null, whi
h is a reasonable assertion when the result is
onsidered in
onjun

tion with the other estimates. Nonetheless, the presen
e of zero
oeÆ
ients at
these leads is not in
onsistent with the theory. The partial R2 (Shea [1997℄)
for ea
h of the regressors is about 0.10, whi
h raises the possibility of the
size distortions owing to weak instruments that are dis
ussed by Bound et al.
[1989℄, Sto
k, Wright, and Yogo [2002℄, and others. These distortions may
ause the true signi
an
e level of the tests to be understated. Notwithstand
ing these possible distortions, the fa
t that the partial R2 does not de
line
with the forward lead oers partial support for the gestation lag story, as does
the apparent ee
tiveness of deep lags as instruments. Considered
olle
tively,
the estimates are suggestive of an eightquarter building horizon, whi
h is in
line with the estimates that Koeva [2000℄ obtained using a nonparametri
methodology. This estimate,
ombined with the planning estimate of one year
obtained in the previous se
tion, suggests a total gestation lag for new
apital
25 In order to preserve the auto
orrelation stru
ture of the estimates in the bootstrap
simulation, I resample blo
ks of twelve adja
ent observations.
26 I report bias
orre
ted intervals at a 90% signi
an
e level. Intervals were also
al
ulated
for signi
an
e levels of 95% and 99%, for whi
h I only report signi
an
e.
27
of about three years.
A
ording to the stru
tural spe
i
ation in (32), the
oeÆ
ients bj should
sum to (1 ) 1 over the building horizon. Sin
e
apital's share of output is
roughly 1/3 in aggregate data, the estimates should sum to about three. A
model with a standard oneperiod time to build
apital a
umulation identity
should satisfy the restri
tion that b1 = 3. The fa
t that this null is easily
reje
ted provides eviden
e against this alternative. However, the null that the
umulative sum of the estimated
oeÆ
ients is three
annot be reje
ted using
the bootstrapped
onden
e intervals, for signi
an
e levels of ten per
ent or
higher. If the building horizon is interpreted as eight periods, the 90% upper
signi
an
e level is about 3.03, while at eleven periods, the upper limit rises to
about 3.78.27 This reinfor
es the building horizon estimate of eight quarters.
The reasonableness of an eight quarter building horizon
an also be assessed
using an alternative test. A
ording to the generalized pro
ess for measured
apital growth in (25), the un
onditional auto
orrelation of measured
apital
growth at a given lag
annot be zero unless that lag ex
eeds the building
horizon.28 Beyond the building horizon, this
orrelation should eventually go
to zero, although it may extend beyond the building horizon if the growth
rate in produ
tive
apital is serially
orrelated. Therefore, an upper bound
on the building horizon is the lag at whi
h the un
onditional auto
orrelation
of measured
apital growth is statisti
ally zero. Consider the
orrelogram for
g~tK in Figure 8. These
orrelations suggest that the measured growth rate
in
apital is un
onditionally auto
orrelated up to ninth lag, at ten per
ent
signi
an
e. This suggests an upper bound for the building period of nine
quarters, slightly higher than the estimate obtained above.
28
and non
onvex adjustment
osts, transa
tion
osts, and irreversibility. Sin
e
the identifying restri
tion is reasonable for most models, the properties of the
estimated impulse responses
an be
ompared to their respe
tive predi
tions.
It is important to assess the models using reasonable standards, due to the
nature of smallsample VAR estimation. It is typi
al for identied VARs to
estimate a smooth impulse response, even if the datagenerating pro
ess has
more welldened
hara
teristi
s. Moreover, most of the wellknown results
from alternative models are demonstrated in a partial equilibrium setting.
Pri
e adjustment in general equilibrium should tend to smooth results
om
pared to these predi
tions.29 Therefore, it is important to judge the models
by their
onsisten
y with the general
hara
ter of the estimated responses.
Some reasonable impli
ations of the gestation lag model are as follows.
Due to the planning lag, measured
apital growth should respond sluggishly
to sho
ks. If there is a signi
ant gestation horizon, measured
apital growth
should rea
t mu
h more strongly to permanent innovations than to temporary
innovations of the same magnitude. Given the sizable gestation lags estimated
above, it would be reasonable to expe
t little or no response of
apital growth
to temporary sho
ks. Consequently, almost all of the varian
e of investment
should be attributable to permanent sho
ks. In
omparison, Q and the rate of
ash
ow should respond immediately to both disturban
es, with the response
limited to the duration of the gestation horizon. The
ompli
ations that arise
due to the mismeasurement of produ
tive
apital should also be
onsidered.
For sho
ks that prompt investment,
ash
ow should de
line monotoni
ally
over the
ourse of the building period, be
ause the measured
apital sto
k (in
its denominator) anti
ipates the a
tual produ
tive sto
k. This ee
t should
not o
ur for Q, sin
e it is roughly oset by the ee
t of the rm's ongoing
a
umulation of
apital during the building period on market value. Signi
ant
proportions of the variation in Q and
ash
ow should be attributable to both
temporary and permanent sho
ks.
Alternative models broadly imply that aggregate investment should respond
immediately to permanent sho
ks. In a model with
onvex adjustment
osts,
the response attenuates over time. Other models, su
h as xed adjustment
osts and irreversibility, imply a more
on
entrated response. Broadly, these
models are well prote
ted by a null that the response to the permanent sho
k is
not upwardsloping over some horizon. The response to temporary sho
ks for
alternative models are more diÆ
ult to assess. A nonpositive response is evi
29 For example, Thomas [2002℄ demonstrates that the lumpiness of mi
rolevel investment
suggested by a partial equilibrium model with transa
tion
osts will be smoothed
onsider
ably in aggregate general equilibrium.
29
den
e against a
onvex adjustment
ost model{if the sho
k ae
ts q , it should
prompt investment. In models with xed adjustment
osts or irreversibility,
it is sensible to think that rms are relu
tant to adjust to temporary sho
ks.
However, there is little reason to believe that su
h rms would redu
e invest
ment. With this in mind, a null that the response is nonnegative is more than
adequate to prote
t these models.
I estimate two separate bivariate stru
tural VARs. Spe
i
ation (1)
om
bines measured
apital growth (in annual per
entage terms) and the log of
measured
ash
ow (Yt1 = [~gtK+1 ; ln ~t ℄0 ), while spe
i
ation (2)
ombines the
apital growth measure and the log of Tobin's Q (Yt2 = [~gtK+1 ; ln Q~ t ℄0 ). For ea
h
system, I estimate a VAR of the form
h 0 i
Ytj j
= B0 + B1j Ytj j j j
1 + : : : + Bp Yt p + et ; where E ejt ejt = j ;
and p is the number of lags.30 The estimated VARs for j = 1; 2 are then
onverted to stru
tural moving average form
1
X j j 0
(33) Ytj = jY + ji t i ; t i ; where jY = E [Yt ℄ ;
i=0
where tj i and jt i are the permanent and temporary sho
ks at time t i,
and the ji are (2x2) matri
es of stru
tural
oeÆ
ients. The identi
ation of
ea
h system rests upon the assumption that
s
ln Kt+s X gtK+1+j
lim = lim = 0;
s!1 t s!1
j =0
t
so that the
hanges in the measured
apital growth prompted by the temporary
sho
k sum to zero.
Generally, the identi
ation methodology requires both variables in Yt to
be stationary, and the results are sensitive to departures from this
ondition.
This sensitivity is a
ommon empiri
al problem asso
iated with zerofrequen
y
onstraints. For instan
e, Blan
hard and Quah [1989℄ make adjustments for
nonstationarity in the unemployment rate, from whi
h they remove a tted
linear time trend. Re
all that the eviden
e for stationarity of Q is ambigu
ous: Di
keyFuller tests fail to reje
t a unit root, while the varian
e ratio test
suggests stationarity. To avoid problems asso
iated with the potential non
stationarity of Q, I eliminated a very low frequen
y trend using an HP lter.31
30 The lag length is
hosen a
ording to the AIC.
31 The lter was estimated with = 99999. The results seem fairly robust to other
hoi
es.
30
The rationale behind applying this lter is that the s
ope of the theory is
limited to movements in Q up to the gestation lag. Arguably, the lower fre
quen
ies re
e
t mismeasurement of tax ee
ts, intangibles, and other things
that are outside of the theory. Figure 6 shows the tted trendline against
a
tual Tobin's Q, in logs. The detrended series of (logged) Q is the a
tual
series minus the trendline.
For robustness, I report 90 per
ent
onden
e intervals estimated using
two alternative methods. The rst intervals, whi
h are denoted with \
," are
al
ulated using the asymptoti
(normal) distribution of the impulse
response (see Lutkepohl [1993℄). The se
ond set of intervals, denoted with
\ ", employ the bootstrapafterbootstrap method of Kilian [1998℄, whi
h
is more robust in small samples.32
Figures 10 and 11 show the impulse response estimates for spe
i
ations
j = 1; 2. In many respe
ts, the
hara
ter of these responses is
onsistent with
the predi
tions of the gestation lag model. In both spe
i
ations,
apital
growth has a humpshaped response to the permanent sho
ks that, although
signi
ant on impa
t, peaks at a lag of three to four quarters. The timing of
this peak is roughly
onsistent with the planning lag estimated in the previous
se
tion. Both responses remain positive and signi
ant at lags of up to 15
quarters. Investment exhibits no signi
ant response to the temporary sho
k
in either spe
i
ation. This is
onsistent with the gestation lag model, but
may also be
onsistent with irreversibility or transa
tion
ost models. Cash
ow and Q respond to both temporary and permanent innovations in a similar
manner, peaking near the time of impa
t, then attenuating to zero over time.
The response of
ash
ow to the permanent sho
k de
lines faster than the
orresponding response for Q, whi
h is roughly
onsistent with the model's
predi
tion. Despite this, there is no eviden
e that the
ash
ow response
eventually de
lines below zero over the
ourse of the building horizon.
It is notable that the magnitude of the responses of
ash
ow and Q to
the temporary and permanent sho
ks seem implausibly large relative to the
measured
apital response given the predi
tions of the gestation lag model.
A
ording to the derivations in Se
tion II, the response of measured
ash
ow
to a permanent sho
k should be no larger than b
within the gestation period.
In annual per
entage terms, the response of measured
apital growth at horizon
P j < J should be 400
~J j . Sin
e the expenditure shares sum to one, this
suggests that the ratio of the responses should average 400=bJ over the
ourse
32 In all
ases, I perform 5000 repli
ations of the rst stage of the bootstrap of the pro
edure
(whi
h
orre
ts for bias in the estimated VAR
oeÆ
ients), and 5000 repli
ations of the
se
ond stage of the pro
edure (whi
h uses the
orre
ted
oeÆ
ient estimates).
31
of the building horizon.33 When the produ
tion fun
tion is CobbDouglas, b
an be no larger than labor's in
ome share. Assuming that this share is about
2=3, the ratio of the
apital growth and
ash
ow responses should ex
eed
400~B j =b 600~B j at any given horizon, and should be larger than 600=J ,
on average. Cursory examination of Figure 10 suggests that the ratio falls well
below this magnitude for any reasonable gestation horizon. For instan
e, the
ratio of the two responses averages around 25 for a gestation horizon of ten
quarters, well below the minimal ben
hmark of 60.
One possible explanation for this dis
repan
y is that the degree of fa
tor
substitutability imposed by CobbDouglas is too strong, whi
h dampens the
magnitude of the ex post rents predi
ted by the theory. A greater degree
of
omplementarity would magnify the sensitivity of
ash
ow (and Q) to
imbalan
es between the fri
tionless demand for
apital servi
es and the xed ex
post supply of produ
tive
apital. Re
all that when the produ
tion fun
tion is
CES and labor supply is inelasti
, the magnitude of b is inversely proportional
to the elasti
ity of substitution between
apital and labor. For this
ase, a
substitution elasti
ity of 2=5 would be roughly suÆ
ient to justify the relative
magnitudes of the
apital and
ash
ow responses in the pre
eding example for
J = 10. A low elasti
ity of substitution would also explain why measured
ash
ow and Q fail to de
line below zero over the
ourse of the building horizon,
be
ause this only o
urs when b < 1.
The upper lefthand panels of Figures 12 and 13 test, for ea
h spe
i
a
tion, whether the upwardsloping
hara
ter of the investment response to the
permanent sho
ks is statisti
ally signi
ant. For ea
h spe
i
ation, these g
ures show the rstdieren
e of the response, and the 10 per
ent lower tail
for the distribution of this dieren
e. A lower tail above zero
orresponds to
a reje
tion of the null that the rstdieren
e is nonpositive at 10 per
ent
signi
an
e. In both spe
i
ations, this null
an be reje
ted for the rst few
lags of the response. Figures 14 and 15 are an alternative test for a delayed
response. These gures plot the impulse response net of the impa
t ee
t,
along with the 10 per
ent lower tail of the distribution of this statisti
. These
tests
onrm that the delayed response of investment to permanent sho
ks is
statisti
ally signi
ant, whi
h provides eviden
e against models that have no
planning delay. The lower lefthand panels in ea
h gure indi
ate that there
are no signi
ant delays in the responses of
ash
ow and Q, whi
h is also
onsistent with the model.
The fore
ast error varian
e de
ompositions for ea
h variable largely
onform
to the predi
tions of the gestation lag model. Figures 16 and 17 report fore
ast
33 Note that
is not identied in either response.
32
error varian
e de
ompositions for spe
i
ations j =1; 2. In ea
h panel, the area
below the line is the proportion of the fore
ast error varian
e at a given horizon
that is attributable to the permanent sho
k. The left panels of the two gures
indi
ate that almost all of the fore
ast error varian
e of
apital growth at
ea
h horizon
an be attributed to permanent sho
ks. As the fore
ast horizon
be
omes large, this proportion approa
hes the proportion of the un
onditional
varian
e that
an be attributed to the permanent sho
k. The plots suggest
that permanent sho
ks a
ount for almost all of the fore
ast error varian
e
of
apital growth at all horizons, and that this proportion in
reases with the
horizon length. The right panels in ea
h gure show fore
ast error varian
e
de
ompositions for
ash
ow and Q. These indi
ate that temporary sho
ks
a
ount for a more than onehalf of the fore
ast error varian
e of ea
h variable.
This suggests that temporary sho
ks are an important part of the variation in
Q and
ash
ow, but not important for the variation of investment.34
A nal
on
ern is whether the responses reported in this se
tion are robust
to other identi
ation s
hemes for temporary and permanent sho
ks. In order
to address this
on
ern, I reestimated the impulse responses in Figures 10 and
11 using a twostage pro
edure that identies the temporary and permanent
disturban
es using independent data. In the rst stage, I estimated temporary
and permanent innovations using a separate bivariate system
ontaining quar
terly data on output growth and the (ex post) real rate on 90day treasury
bills.35 As in the previous systems, identi
ation was a
hieved by only allow
ing the permanent sho
k to ae
t the long run level of output. The estimated
stru
tural innovations from this system were then used to obtain impulse re
sponses for
apital growth,
ash
ow, and Q, using the te
hnique suggested in
Chang and Sakata [2003℄. Spe
i
ally, the response of ea
h variable at lag n is
obtained by regressing the variable on the n th lag of the stru
tural innovations
estimated from the rst system.
Figure 18 shows the impulse response of output growth and the interest
rate to the temporary and permanent disturban
es. The two lefthand panels
depi
t responses to the permanent sho
k, whi
h
auses the real interest rate
and output growth to rise on impa
t and then fall o over time. These ef
fe
ts are
onsistent with the typi
al
hara
teristi
s of a favorable te
hnologi
al
innovation. The two righthand panels depi
t responses to the temporary dis
turban
e. These responses resemble the ee
ts of a
ontra
tionary monetary
disturban
e, raising the real interest rate and redu
ing output growth.
34 This feature is not imposed by the identi
ation s
heme. In prin
iple, the temporary
sho
k
an
ompose an arbitrarily large portion of the fore
ast error varian
e of
apital
growth.
35 In
ation was proxied using the rate of GDP pri
e in
ation for nonnan
ial
orporations.
33
Figure 19 graphs the impulse responses of
apital growth,
ash
ow, and Q
to the temporary and permanent innovations. Conden
e intervals for these
responses were generated using a bootstrapafterbootstrap te
hnique that
or
re
ts for small sample biases in both the identifying VAR and the OLS im
pulse response estimates.36 The top two panels show that
apital growth has a
humpshaped response to the permanent disturban
e that peaks between the
ve and tenquarter horizons, and a response to the temporary disturban
e
that is
lose to zero at all horizons. Neither response is statisti
ally signi
ant
at standard signi
an
e levels.37 Among other things, this la
k of signi
an
e
ould re
e
t a loss of power from utilizing the twostage pro
edure rather than
the more dire
t onestage methodology. The responses of Q to the favorable
permanent disturban
e and the adverse temporary disturban
e are (roughly)
mirror images, with ea
h response peaking near impa
t, then following a rough
pattern of attenuation. The
ash
ow responses in the middle two panels are
slightly more nebulous. Cash
ow de
lines in response to the adverse tempo
rary sho
k, albeit with a hump shape that peaks at ve quarters. The response
of
ash
ow to the favorable permanent disturban
e is positive on impa
t, and
attenuates to zero after about seven quarters. Although these results are not
as
lean as those obtained using the more dire
t methodology utilized earlier
in this se
tion, they seem to give some
autious support for those estimates.
This paper demonstrates that gestation lags are both theoreti
ally impor
tant and empiri
ally relevant. A simple model of aggregate investment with
distin
t gestation lags for planning and building
an allow movements in
ash
ow and Q that are noisy indi
ators of investment. This relationship owes
to the fa
t that both Q and
ash
ow adjust to re
e
t the short run s
ar
ity
of produ
tive
apital. All unanti
ipated disturban
es in the e
onomy
ause
a
tual holdings of produ
tive
apital to diverge from what rms would hold
36 Ea
h sample was generated by estimating a VAR(8) model for a ve
tor
ontaining
output growth, the real interest rate,
apital growth,
ash
ow, and Q. Then, estimates of
the permanent and temporary innovations were obtained using a bivariate VAR
ontaining
output growth and the real interest rate. Finally, the responses of
apital growth,
ash
ow, and Q to ea
h innovation were obtained by regressing ea
h variable, separately, on the
ve
tor of estimated innovations for ea
h lag. Ea
h of these three stages were
orre
ted for
smallsample bias using bias estimates from preliminary bootstrap experiments. The bias
orre
tions for ea
h stage were estimated in stages, using bias
orre
ted repli
ations of the
data from the previous stage.
37 The response to the permanent sho
k at a horizon of eight quarters is signi
ant at
25 per
ent. It is signi
ant at less than ten per
ent when
ash
ow is ex
luded from the
bootstrap simulation.
34
in a fri
tionless equilibrium. This
auses a shortterm divergen
e between the
e
onomi
value of new
apital goods and the value of
apital that is already
in pla
e for produ
tion. Sin
e it takes time to add new
apital, su
h diver
gen
es do not always signal investment. Though all sho
ks
reate similar pri
e
signals, only disturban
es that are expe
ted to outlast the gestation period
prompt new investment. The empiri
al estimates in this paper suggest a plan
ning horizon of one year, whi
h is followed by a building horizon of two years.
Hen
e, there is
onsiderable s
ope for temporary sho
ks to
reate noise in the
relationship between investment and Q.
These ndings provide some insight into the empiri
al short
omings of Q
regressions, in
luding the
laim that investment is ex
essively sensitive to
ash
ows. With investment lags, the typi
al regression of
urrent investment on
the
urrent Q is misspe
ied. Both
ash
ows and Q are
orrelated to invest
ment be
ause they
ontain rents that re
e
t the relative s
ar
ity of
apital.38
Consequently, the
oeÆ
ients on Q that are estimated by resear
hers may
re
e
t the imperfe
t
omovement of rents with investment, rather than the
magnitude of quadrati
adjustment
osts. It is easy to see why
ash
ows
might perform well as an additional variable in su
h regressions, even without
nan
ing
onstraints, be
ause they
ontain similar information. Millar [2005℄
demonstrates how gestation lags are problemati
for the standard regression
of investment against Tobin's Q, and proposes alternative spe
i
ations that
a
ount for su
h lags in the presen
e of
onvex adjustment
osts for
apital.
The results of this paper are also relevant for a number of other areas of
study. For instan
e, building lags have important impli
ations for growth a

ounting be
ause they entail the mismeasurement of produ
tive
apital and
te
hnologi
al progress, and for business
y
le theorists be
ause they
ompli
ate the e
onomy's dynami
response to sho
ks. For the investment literature,
I have demonstrated an alternative model that is
hara
terized by deviations
from the fri
tionless equilibrium at higher frequen
ies, but obeys the neo
lassi
al equilibrium in the long run. This spe
i
ation has some promising
properties. It explains why investment is slow to respond to sho
ks, despite
the e
onomi
in
entive for rms to adjust rapidly. It also allows for a range of
hara
teristi
s that are
onsistent with empiri
al fa
ts about aggregate invest
ment. These in
lude lumpiness, serial
orrelation, and a lagged relationship
to output at business
y
le frequen
ies.
38 This nding is similar in
avor to Abel and Eberly [2002℄, who show that the
ash
ows
and Q of monopolisti
rms re
e
t rents that indi
ate growth opportunities.
35
A. Shadow Value Derivations
It is easily veried that the value fun
tion (11) is linearly homogeneous in
the state variables Kt and fsi;t gJi=11 . Therefore, by Euler's theorem, it must
be true that
J 1
Vt X
= q0;t Kt + qi;t si;t ;
p i=1
where
VKt Vsi;t
q0;t and qi;t :
p p
Applying the envelope theorem to (10), these derivatives
an be
al
ulated as
1 j
X R t
t+j
q0;t = ;
j =0
1 Æ p
(
R i (t q0;t+i q0 ) + qi 1 i < B 1
qi;t = :
R i (t q0;t+i q0 ) B i < J:
In taking these derivatives, it is useful to note that
apital a
umulation iden
tity
an be iterated to obtain that
j
X
Kt+j = (1 Æ )j Kt + (1 Æ )i j s1;t+i
i=1
Some additional results are also useful. Taking the
onditional expe
tation of
q0;t at t J , and using the equilibrium
ondition (14), it
an be shown that
t J q0;t = E [qt ℄ = q0 ;
whi
h veries that q0 is the un
onditional shadow value of produ
tive
apital.
Further, it
an be shown that
J 1 R j
X t
t+j
q0;t = q +0 u ;
j =0
1 Æ p
where the summation is limited to the horizon J 1 be
ause rents are always
anti
ipated to be zero beyond the gestation horizon J .
36
B. LogLinearization of Qt
where
u K
!i R i iG ; Gi E t+i for all i 0;
E [Q℄ Kt
Gi
i i+1 + qi (1 Æ )qi+1 ; for i = 1; : : : ; B 2;
E [Q℄
q
B 1 GB 1 B 1 ; and
E [Q℄
X1
B
E [Q℄ = q0 + [Gi (1 Æ )Gi 1 ℄ qi > q0 > 1:
i=1
37
umulation identity
an be iterated ba
kwards to yield that
1
X
K~ t+i+1 = d(L)It+i ; where d(L) = (1 Æ )j Lj :
j =0
Using the arbitrary time to build a
ounting in equations (7) to (9), investment
an be stated as
B
X
It+i = g (L)Kt+J +i ; where g (L) = gJ j Lj ;
j =0
and
8
<B
> j=0
gj B j (1 Æ )B j +1 0 < j < B :
>
:
(1 Æ )1 j=B
By substitution, these two equations suggest that
K~ t+i+1 = m(L)Kt+J +i ; where m(L) d(L)g (L)
is the produ
t of the two lag polynomials. Performing this multipli
ation yields
that
X1
B
P
m(L) = L (L); where (L) = B j Lj :
j =0
Therefore, the a
ounting measure of
apital maps to the produ
tive measure
by
K~ t+i+1 = (L)Kt+B+i :
The a
ounting measure of
apital growth is
ln K~ t+1 = (L) ln Kt+B :
Loglinearizing this around the un
onditional expe
tation yields that
ln K~ t+1 ~(L)gtK+B ;
where
X1
B
G B
X
~(L) = ~B j Lj ; ~j = B j j
P
0; and ~j = 1:
j =0 k G k j =1
k=1
38
D. Interpretation of Regression Coeffi
ients in Planning Lag
Regression
Given the solution for the growth rate of the produ
tive
apital in (18),
dgtK+B 1 d ln Et P [Ztb+B ℄
=
dsr
~t P b dsr
~t P
In the spe
ial
ase where the te
hnology and labor supply fa
tors are indepen
dent, the form of Z in (6)
an be used to show that
h i h i
ln Et P [Ztb+B ℄ = ln Et P ZtT+B b(1+ ) + ln Et P ZtL+B b ;
Assume that the so
ial planner
hooses a
onsumption and investment plan
to maximize the expe
ted value of the lifetime utility
1
X
U= j tEt [ln Ct+j ℄ ;
j =t
subje
t to the feasibility
onstraint that F Kt+j ; ZtT+j Lt+j = Ct+j + It+j for
all j 0, where F takes the spe
i
ation in (1). The evolution of
apital is
des
ribed by equations (7) to (9) with P = 0, and Lt+j is normalized to one
for all periods. The log of te
hnology follows a random walk with a
onstant
drift equal to the rate of growth ln G, so that ln ZtT+1 = ln G + ln ZtT + t .
The optimization problem redu
es to the intertemporal rst order
ondition
B
X 1 ZT 1
j gj Et = B Et (1 ) t+B ;
j =0
Ct+j Kt+B Ct+B
39
and the
onstraint that
B
X
Ct+s = Kt1+s ZtT+s gB j Kt+j
j =0
su
h that the rst order
onditions were satised, using a numeri
al solver
algorithm. Generally there will be many linear solutions of this form that
satisfy the optimization
onditions for a given B > 0. The solution set was
limited to those that implied a stable AR pro
ess for
apital, i.e., those for
whi
h the largest modulus of the roots of the polynomial
XB 1
1 LB j
j =0 kj
F. Data Appendix
A time series was
onstru
ted for
ows of real quarterly aggregate invest
ment from 1946Q4 to 2002Q4 using data from the Federal Reserve Board's
Flow of Funds (FF) and
apital sto
k estimates from the Bureau of E
onomi
Analysis (BEA). Ea
h quarter's investment was determined by dividing the
40
FF gure for nonnan
ial, nonfarm
orporations (NFNFC) by the impli
it
pri
e de
ator for quarterly nonresidential xed investment from BEA Table
7.6.
To obtain the series for the real
apital sto
k, I iterated the
apital a
u
mulation identity (7) for a one period time to build. The initial estimate of
the real
apital sto
k was determined by dividing the nominal value of nonres
idential xed
apital for nonnan
ial
orporations at the end of 1946 by the
pri
e de
ator for the last quarter. In order to minimize the error owing to the
estimate of the initial
apital sto
k, I do not use the
apital sto
k estimates
prior to 1959Q3. Depre
iation rates were
al
ulated as a weighted average of
the BEA depre
iation rates for stru
tures, equipment, and IT
apital, with
weights set equal to the share of ea
h
ategory in the nominal value of the
aggregate sto
k of nonresidential
apital for nonnan
ial
orporations. The
depre
iation rate for ea
h quarter is set to the
orresponding annual rate.
3. Tobin's Q
42
4. Rate of Cash Flow
Cash
ows per unit of
apital were determined by dividing after tax
ash
ows by the repla
ement value of produ
tive
apital:
t
t :
pt 1 Kt
After tax
ash
ows ( t ) for ea
h quarter were
al
ulated using FF data for
NFNFC, and BEA quarterly aggregates. To determine the
ash
ow, I added
the book value of aftertax prots from FF, the value of
apital
onsumption
allowan
es from FF, and net interest payments. Net interest payments were
al
ulated using BEA data, by dedu
ting an estimate of net interest for
or
porate farms from the net interest gure for nonnan
ial
orporations. This
nominal gure was then adjusted for in
ation during the quarter using the rate
of in
rease in the quarterly GDP de
ator for nonnan
ial
orporations.
43
Table 1: Sample moments of the tax
orre
ted data
g~tK+1 ln Q~ t ln (~t =p)
mean .0111 1.4505 .0628
stdev .0029 .5969 .0062
orr(~gt+1 ; )
K .5028 .5432
orr(ln Qt ; )
~ .3659
Sample Period: 1959Q3 to 2002Q4 (174 observations). g~tK+1 rep
resents the growth rate in measured
apital, while Q~ and ~ denote
the measured values of Tobin's Q, and the rate of
ash
ow, re
spe
tively.
44
Table 3: Planning Horizon Estimates by OLS
Measured Capital Growth on Lags of Puried Solow Residual
lag d^i ser lag d^i ser
0 .0052 .0203 8 .0351 .0168z
1 .0026 .0246 9 .0282 .0129z
2 .0092 .0222 10 .0275 .0133z
3 .0195 .0171 11 .0232 .0146
4 .0269 .0143y 12 .0171 .0158
5 .0328 .0148z 13 .0201 .0144
6 .0349 .0169z 14 .0146 .0134
7 .0377 .0172z
onst .0101 .0008#
Sele
ted Tests Using Estimated CoeÆ
ients
sum lags
oef ser CIb
90
0 to 10 .2492 .1551 .0231,.6214
4 to 10 .2463 .0993 .0480,.4408
4 to 7 .1324 .0575 .0105,.2603
0 to 3 .0261 .0795 .1001,.1896
(4 to 7)  (0 to 3) .1063 .0532 .0132,.1873
Signi
an
e Levels: y10%, z5%, #1%; R 2 = .0068; dw = .0680. Sample Pe
riod: 1965Q3 to 2002Q2 (150 observations). Standard errors are robust for
heteroskedasti
ity and auto
orrelation (NeweyWest maximum lag = 15).
45
Table 4: Building Horizon Estimates by Instrumental Variables
Measured Capital Growth on Instrumented Leads of Impli
it Produ
tive Capital Growth
lead h^ i ser CIb
90 Rp2 lead h^ i ser CIb
90 Rp2
1 .0706 .1282 .0037,.4323 .1186 7 .2458 .0747# .2482,.6667# .1137
2 .1372 .1466 .0670,.5651z .1060 8 .2201 .0698# .2014,.6304# .1183
3 .0706 .1239 .0443,.3716 .0992 9 .1049 .1396 .0228,.2956 .0851
4 .1056 .1076 .0094,.3917y .1171 10 .1092 .1131 .0860,.2833 .0952
5 .2314 .1482 .2182,.6620# .0843 11 .0759 .1112 .1375,.2391 .1162
6 .2539 .1101z .2390,.6845# .1208 12 .0088 .1089 .3566,.0771 .1040
Sele
ted Tests Using Estimated CoeÆ
ients
linear
ombination
oef ser CIb
90
h1 + : : : + h8 1.3352 .5886 1.2942, 3.0308
h1 + : : : + h9 1.4401 .5989 1.3643, 3.3450
h1 + : : : + h10 1.5493 .5762 1.4664, 3.6412
h1 + : : : + h11 1.6251 .5598 1.5424, 3.7840
Signi
an
e Levels: y10%, z5%, #1%. Sample Period: 1965Q3 to 2002Q2 (150 observations). In
struments (28): gtH ; : : : ; gtH 13 , g~tK ; : : : ; g~tK 13 . IV standard errors are robust for heteroskedasti
ity
and auto
orrelation (NeweyWest maximum lag = 15). Rp2 is the \partial R2 " outlined in Shea
[1997℄, whi
h measures the squared
orrelation between the portion of the regressor that is or
thogonal to the other regressors, and the portion of the tted regressor that is orthogonal to the
other tted regressors. The overidentifying restri
tions
annot be reje
ted at 1% signi
an
e, after
orre
ting for smallsample bias. Bias
orre
ted intervals were
onstru
ted using 50,000 bootstrap
repli
ations, with resampling in blo
ks of 12 adja
ent observations. An in
luded
onstant is not
reported.
46
B ... B i ...
P "planning" periods B "building" periods
Figure 1: Time s ale depi tion of the investment pro ess with gestation lags.
user user
cost Ex post Supply
cost
u0
QUASI
PSfrag repla
ements PSfrag repla
ements
Ex ante Supply u
RENT Ex ante Supply
u
u0 Anticipated Realized
Demand Demand
Kt+J Kt+J
Kt+J K Kt+J K
"Ex ante" Market "Ex post" Market
47
.02
1960q1
1965q1
1970q1
1975q1
1980q1
1985q1
1990q1
1995q1
2000q1
2005q1
0
1960q1
1965q1
1970q1
1975q1
1980q1
1985q1
1990q1
1995q1
2000q1
2005q1
Quarter
Cash Flows Tax Corrected Cash Flows
Quarter
Figure 3: Plot of measured
apital Figure 4: Plot of the rate of
ash
ow.
growth.
1.5
4
1
3
.5
2
0
−.5
1
−1
0
1960q1
1965q1
1970q1
1975q1
1980q1
1985q1
1990q1
1995q1
2000q1
2005q1
1960q1
1965q1
1970q1
1975q1
1980q1
1985q1
1990q1
1995q1
2000q1
2005q1
Quarter
Quarter
Log of Q Fitted Trend
Q Tax Corrected Q
Figure 5: Plot of Tobin's Q. Figure 6: Log of Tobin's Q and tted
trend
1.00
.04
.02
Autocorrelations of gk
0.50
0
−.02
0.00
−.04
1960q1
1965q1
1970q1
1975q1
1980q1
1985q1
1990q1
1995q1
2000q1
2005q1
−0.50
Quarter 0 10 20 30
Lag
Cleaned Solow Residuals Growth in Labor Hours Bartlett’s formula for MA(q) 90% confidence bands
Figure 7: Hours growth and puried Figure 8: Correlogram of measured
ap
Solow residuals. ital growth.
48
1
0.9
0.8
0.7
0.6
Percentage
0.5
0.4
0.3 TTB = 1
TTB = 2
TTB = 3
0.2 TTB = 4
TTB = 5
TTB = 6
0.1 TTB = 7
TTB = 8
TTB = 9
0
0 10 20 30 40 50 60 70 80 90 100
Quarters
49
gK gK
t t
0.5 0.5
Permanent
Temporary
0 0
−0.5 −0.5
0 5 10 15 20 0 5 10 15 20
lag lag
πt πt
0.05 0.05
Permanent
Temporary
0 0
−0.05 −0.05
0 5 10 15 20 0 5 10 15 20
lag lag
Figure 10: Impulse responses of the logged rate of
ash
ow and measured
apital growth to temporary and permanent stru
tural innovations.
50
gK gK
t t
0.5 0.5
Permanent
Temporary
0 0
−0.5 −0.5
0 5 10 15 20 0 5 10 15 20
lag lag
Qt Qt
0.1 0.1
0.05 0.05
Permanent
Temporary
0 0
−0.05 −0.05
−0.1 −0.1
0 5 10 15 20 0 5 10 15 20
lag lag
Figure 11: Impulse response of logged Tobin's Q and measured
apital growth
to temporary and permanent stru
tural innovations.
51
K K
dg dg
t t
0.1 0.1
0.05 0.05
Permanent
Temporary
0 0
−0.05 −0.05
−0.1 −0.1
5 10 15 20 5 10 15 20
lag lag
dπ dπ
t t
0.01 0.01
0.005 0.005
Permanent
Temporary
0 0
−0.005 −0.005
−0.01 −0.01
5 10 15 20 5 10 15 20
lag lag
Figure 12: Firstdieren
e of the impulse responses of the logged rate of
ash
ow and measured
apital to temporary and permanent stru
tural innovations.
52
d gK d gK
t t
0.1 0.1
0.05 0.05
Permanent
Temporary
0 0
−0.05 −0.05
−0.1 −0.1
5 10 15 20 5 10 15 20
lag lag
d Qt d Qt
0.03 0.03
0.02 0.02
0.01 0.01
Permanent
Temporary
0 0
−0.01 −0.01
−0.02 −0.02
−0.03 −0.03
5 10 15 20 5 10 15 20
lag lag
Figure 13: Firstdieren
e of the impulse responses of logged Tobin's Q and
measured
apital growth to temporary and permanent stru
tural innovations.
53
After impact gK After impact gK
t t
0.3 0.3
0.2 0.2
0.1 0.1
Permanent
Temporary
0 0
−0.1 −0.1
−0.2 −0.2
−0.3 −0.3
5 10 15 20 5 10 15 20
lag lag
After impact πt After impact πt
0.04 0.04
0.02 0.02
Permanent
Temporary
0 0
−0.02 −0.02
−0.04 −0.04
5 10 15 20 5 10 15 20
lag lag
Figure 14: Netofimpa
t impulse response of the logged rate of
ash
ow and
measured
apital growth to temporary and permanent stru
tural innovations.
54
After impact gK After impact gK
t t
0.3 0.3
0.2 0.2
0.1 0.1
Permanent
Temporary
0 0
−0.1 −0.1
−0.2 −0.2
−0.3 −0.3
5 10 15 20 5 10 15 20
lag lag
After impact Qt After impact Qt
0.1 0.1
0.05 0.05
Permanent
Temporary
0 0
−0.05 −0.05
−0.1 −0.1
5 10 15 20 5 10 15 20
lag lag
K
gt πt
1 1
0.9 0.9
0.8 0.8
0.7 0.7
0.6 0.6
0.5 0.5
0.4 0.4
0.3 0.3
0.2 0.2
0.1 0.1
0 0
10 20 30 40 50 60 10 20 30 40 50 60
horizon horizon
The line represents the proportion of the fore
ast error at ea
h horizon that is a
ounted
for by the permanent sho
k.
Figure 16: Fore
ast error varian
e de
omposition for temporary and perma
nent sho
ks in the system with the logged rate of
ash
ow and measured
apital growth.
55
K
gt Qt
1 1
0.9 0.9
0.8 0.8
0.7 0.7
0.6 0.6
0.5 0.5
0.4 0.4
0.3 0.3
0.2 0.2
0.1 0.1
0 0
10 20 30 40 50 60 10 20 30 40 50 60
horizon horizon
The line represents the proportion of the fore
ast error at ea
h horizon that is a
ounted
for by the permanent sho
k.
Figure 17: Fore
ast error varian
e de
omposition for temporary and perma
nent sho
ks in the system with logged Tobin's Q and measured
apital growth.
gY gY
t t
4 4
2 2
Permanent
Temporary
0 0
−2 −2
−4 −4
0 5 10 15 20 0 5 10 15 20
lag lag
r r
t t
1.5 1.5
1 1
Permanent
Temporary
0.5 0.5
0 0
−0.5 −0.5
−1 −1
−1.5 −1.5
0 5 10 15 20 0 5 10 15 20
lag lag
Figure 18: Impulse response of output growth and the real interest rate to
temporary and permanent stru
tural innovations.
56
gK gK
t t
1 1
Permanent
Temporary
0.5 0.5
0 0
−0.5 −0.5
−1 −1
0 5 10 15 20 0 5 10 15 20
π π
t t
0.2 0.2
0.1 0.1
Permanent
Temporary
0 0
−0.1 −0.1
−0.2 −0.2
0 5 10 15 20 0 5 10 15 20
Qt Qt
0.05 0.05
Permanent
Temporary
0 0
−0.05 −0.05
0 5 10 15 20 0 5 10 15 20
Figure 19: Impulse response of measured
apital growth, the logged rate of
ash
ow and logged Tobin's Q to separatelyidentied temporary and perma
nent stru
tural innovations.
57
Table 5: Stylized Balan
e Sheet
Assets Liabilities + Equity
FINASt DEBTt
PVCCAt
INVt
RESKt
Qt pt 1 Kt EQUt
Total Market Value Total Market Value
58
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