Business fixed investment spending: a critical survey of modeling strategies, empirical results, and policy implications

Abstract

This study has offered a critical review of literature on business fixed investment spending, and has assessed current state of and future research agenda. To place some structure on this vast literature, survey has been organized according to two principles. The first sorted models by whether dynamics were introduced into econometric equation implicitly or explicitly. Benchmark models were developed for all of models discussed in this survey. The second organizing principle focused on four important issues (listed in Section I) that have been faced repeatedly by investment researchers. A number of these issues have been addressed reasonably well, and most recent models are theoretically consistent and isolate effects of expectations and technology on econometric equation. Such success has been purchased partly by maintaining a number of uncomfortable restrictions, and research agenda aims to expand our view of firm and margins along which it operates. A final issue concerns relative importance of prices vs. quantities vs. shocks as determinants of investment. While there is clearly no uniformity in results and role of shocks remains to be assessed, it appears to this author that, on balance, response of investment to prices tend to be quite small and unimportant relative to quantity variables. The fundamental problem facing applied econometrician is how to generate and interpret econometric evidence when available data are non-experimental and have limited and noisy variation. The most direct solution would be to obtain better data, but collecting comparable data for firms is a rather difficult and expensive task. An alternative research strategy would use sophisticated statistical techniques to attempt to correct for various difficulties. Since these procedures are based frequently on large samples of spotlessly measured data, doubts exist about their usefulness for applied work. Statistical research would be particularly informative if it focused on small sample properties of various estimators, highlighting their robustness to non-classical measurement error and other sources of misspecification that plague all econometric equations. As has been argued throughout this survey, exploiting information and restrictions provided by theory is likely to be most productive approach. Clearly there is a tension between restrictions to maintain and those to test. These and many other problems will arise in empirical applications, and progress will occur only after comparing results and assumptions from many different models. No single study, regardless of generality of specifications nor richness of data, will deliver the definitive test. As a result, disciplined discourse fostered by an explicit modeling approach is needed for interpreting various studies and extending our understanding of firm behavior. Despite these decided benefits, our review of previous investment studies and numerous caveats mentioned throughout this survey remind us of limits of our knowledge and degree of humility appropriate when interpreting all econometric work.

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