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Tobin's Q and asset returns: implications for business cycle analysis

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  • Lawrence J. Christiano
  • Jonas D.M. Fisher

Abstract

The marginal cost of plant capacity, measured by the price of equity, is significantly procyclical. Yet, the price of a major intermediate input into expanding plant capacity, investment goods, is countercyclical. The ratio of these prices is Tobin's q. Following convention, we interpret the fact that Tobin's q differs from unity at all, as reflecting that there are diminishing returns to expanding plant capacity by installing investment goods ("adjustment costs"). However, the phenomenon that interests us is not just that Tobin's q differs from unity, but also that its numerator and denominator have such different cyclical properties. We interpret the sign switch in their covariation with output as reflecting the interaction of our adjustment cost specification with the operation of two shocks: one which affects the demand for equity and another which shifts the technology for producing investment goods. The adjustment costs cause the two prices to respond differently to these two shocks, and this is why it is possible to choose the shock variances to reproduce the sign switch. These model features are incorporated into a modified version of a model analyzed in Boldrin, Christiano and Fisher (1995). That model incorporates assumptions designed to help account for the observed mean return on risk free and risky assets. We find that the various modifications not only account for the sign switch, but they also continue to account for the salient features of mean asset returns. We turn to the business cycle implications of our model. The model does as well as standard models with respect to conventional business cycle measures of volatility and comovement with output, and on one dimension the model significantly dominates standard models. The factors that help it account for prices and rates of return on assets also help it account for the fact that employment across a broad range of sectors moves together over the cycle.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Chicago in its series Working Paper Series, Macroeconomic Issues with number 95-14.

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Date of creation: 1995
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Handle: RePEc:fip:fedhma:95-14

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Keywords: Business cycles ; Capital assets pricing model;

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References

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  1. Christiano, Lawrence J., 1988. "Why does inventory investment fluctuate so much?," Journal of Monetary Economics, Elsevier, vol. 21(2-3), pages 247-280.
  2. Gary Hansen, 2010. "Indivisible Labor and the Business Cycle," Levine's Working Paper Archive 233, David K. Levine.
  3. Christiano, Lawrence J & Eichenbaum, Martin, 1992. "Current Real-Business-Cycle Theories and Aggregate Labor-Market Fluctuations," American Economic Review, American Economic Association, vol. 82(3), pages 430-50, June.
  4. Hall, Robert E, 1978. "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 971-87, December.
  5. John H. Cochrane & Lars Peter Hansen, 1992. "Asset Pricing Explorations for Macroeconomics," NBER Chapters, in: NBER Macroeconomics Annual 1992, Volume 7, pages 115-182 National Bureau of Economic Research, Inc.
  6. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-43, June.
  7. Jeremy Greenwood & Zvi Hercowitz & Per Krusell, 1992. "Macroeconomic implications of investment-specific technological change," Discussion Paper / Institute for Empirical Macroeconomics 76, Federal Reserve Bank of Minneapolis.
  8. Richard Rogerson, 2010. "Indivisible Labor, Lotteries and Equilibrium," Levine's Working Paper Archive 250, David K. Levine.
  9. Quah, Danny, 1990. "Permanent and Transitory Movements in Labor Income: An Explanation for "Excess Smoothness" in Consumption," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 449-75, June.
  10. Fisher, Jonas D. M., 1997. "Relative prices, complementarities and comovement among components of aggregate expenditures," Journal of Monetary Economics, Elsevier, vol. 39(3), pages 449-474, August.
  11. Kevin M. Murphy & Andrei Shleifer & Robert W. Vishny, 1989. "Building Blocks of Market Clearing Business Cycle Models," NBER Working Papers 3004, National Bureau of Economic Research, Inc.
  12. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  13. Eichenbaum, Martin & Hansen, Lars Peter, 1990. "Estimating Models with Intertemporal Substitution Using Aggregate Time Series Data," Journal of Business & Economic Statistics, American Statistical Association, vol. 8(1), pages 53-69, January.
  14. Gibbons, Michael R., 1989. "On the volatility of bond prices," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 31(1), pages 139-175, January.
  15. Lucas, Robert E, Jr & Prescott, Edward C, 1971. "Investment Under Uncertainty," Econometrica, Econometric Society, vol. 39(5), pages 659-81, September.
  16. Robert J. Shiller, 1980. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," NBER Working Papers 0456, National Bureau of Economic Research, Inc.
  17. Hansen, Lars Peter & Singleton, Kenneth J, 1982. "Generalized Instrumental Variables Estimation of Nonlinear Rational Expectations Models," Econometrica, Econometric Society, vol. 50(5), pages 1269-86, September.
  18. Benhabib, Jess & Rogerson, Richard & Wright, Randall, 1991. "Homework in Macroeconomics: Household Production and Aggregate Fluctuations," Journal of Political Economy, University of Chicago Press, vol. 99(6), pages 1166-87, December.
  19. Robert J. Gordon, 1990. "The Measurement of Durable Goods Prices," NBER Books, National Bureau of Economic Research, Inc, number gord90-1.
  20. Gordon, Robert J., 1990. "The Measurement of Durable Goods Prices," National Bureau of Economic Research Books, University of Chicago Press, edition 1, number 9780226304557, October.
  21. Hansen, Lars Peter & Singleton, Kenneth J, 1983. "Stochastic Consumption, Risk Aversion, and the Temporal Behavior of Asset Returns," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 249-65, April.
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Citations

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Cited by:
  1. Michele Boldrin & Lawrence J. Christiano & Jonas D.M. Fisher, 1997. "Habit persistence and asset returns in an exchange economy," Working Paper Series, Macroeconomic Issues WP-97-04, Federal Reserve Bank of Chicago.
  2. Greenwood, Jeremy & Hercowitz, Zvi & Krusell, Per, 2000. "The role of investment-specific technological change in the business cycle," European Economic Review, Elsevier, vol. 44(1), pages 91-115, January.
  3. Robert G. King & Sergio T. Rebelo, 2000. "Resuscitating Real Business Cycles," RCER Working Papers 467, University of Rochester - Center for Economic Research (RCER).
  4. Ramey, Valerie A & SHAPIRO, MATTHEW D, 1998. "Displaced Capital," University of California at San Diego, Economics Working Paper Series qt49k7n14z, Department of Economics, UC San Diego.
  5. Ziv Chinzara & Radhika Lahiri & En Te chen, 2012. "Financial Globalisation and Sectoral Reallocation of Capital in South Africa," School of Economics and Finance Discussion Papers and Working Papers Series 286, School of Economics and Finance, Queensland University of Technology.
  6. Miquel Faig, 1997. "INVESTMENT IRREVERSIBILITY IN GENERAL EQUILIBRIUM: Capital Accumulation, Interest Rates, and the Risk Premium," Working Papers faig-97-01, University of Toronto, Department of Economics.
  7. Miquel Faig, 1999. "Asset Pricing, Growth, And The Business Cycle With Irreversible Investment," Working Papers faig-98-02, University of Toronto, Department of Economics.
  8. Lars-Alexander Kuehn, 2007. "Time-to-Build and Asset Prices," 2007 Meeting Papers 1015, Society for Economic Dynamics.
  9. Gregory W. Huffman & Mark A. Wynne, 1995. "The role of intratemporal adjustment costs in a multi-sector economy," Working Papers 9508, Federal Reserve Bank of Dallas.

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