Financial Volatility and the q Theory of Investment

Abstract

This paper has two major objectives. The first is to explain a stylized fact that investment is highly correlated with current real variables such as profits. The second is to give a rigorous interpretation to the widely held view that stock prices are too volatile. We introduce two elements into the q theory of investment: (1) delivery lags and (2) that the profit rate contains more permanent movements than does the discount rate. Then we show that firms rationally ignore temporary fluctuations in the discount rate, and that as a result investment mainly responds to real factors.

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