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BPEA Article

Investment, Output, and the Cost of Capital

Abstract

ONE OF THE BEST-ESTABLISHED FACTS in macroeconomics is that business
fixed investment and output move strongly together over the business
cycle. By contrast, investment and the cost of capital are either uncorrelated
or only weakly correlated. These relationships might appear to
suggest that business fixed investment can be best explained by an
accelerator model of investment, whereby investment responds to
changes in the desired capital stock, itself determined by the demand for
output. The theory behind the accelerator model is akin to the man-onthe-
street view that firms have little incentive to invest when current
prospects for selling the output produced by the new capital are relatively
poor.
The claim that the correlation of output and investment is due to
demand shocks provides a challenge to neoclassical and neo-Keynesian
theories alike. Neoclassical theories of investment view output as the
consequence of firms' choice of capital stock and other factors, not the
cause. Put another way, if the neoclassical model is correct, firms should
use prices and not quantities as signals in making their investment
decisions. The observation that investment and output are strongly
correlated while the cost of capital has little correlation with investment
weighs against the neoclassical model.

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