Modeling aggregate investment under financial constraints

The motivation for this paper has been that standard Euler equations for aggregate investment (EEI) are known to perform poorly empirically. According to the literature, it may be because they fail to account for financial constraints. We contribute to this literature in two ways. First, we introduce a more pragmatic than the standard definition of investment. Second, we construct a modified EEI (MEEI) by combining financially constrained and unconstrained firms in the same manner as in the aggregate consumption literature. The MEEI is an “all-purpose” model in that it can be estimated both when investment and its determinants (relative price of investment, profits, cash flow, etc.) are I(0) variables and when they are I(1) and cointegrated, in which case the MEEI is a non-linear error-correction model for aggregate investment. Using United States (US) aggregate quarterly data, 1947:1–2022:2, we produce evidence supporting the model and estimate that about 30 percent of the US firms forgo attractive investment opportunities because of financial constraints, which therefore hurt economic growth. Issues like aggregation bias, structural instability, and weak identification are addressed. The MEEI can be used for forecasting macroeconomic fluctuations and for enacting stabilization and growth policies.