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UK business investment: long-run elasticities and short-run dynamics

Author

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  • Colin Ellis
  • Simon Price

Abstract

Theory tells us that output, the capital stock and the user cost of capital are related. From the capital accumulation identity, it also follows that the capital stock and investment have a long-run proportional relationship. The dynamic structure thus implies a multi-cointegrating framework, in which separate cointegrating relationships are identifiable. This has been used to justify the estimation of investment equations embodying a reduced-form long-run relationship between investment and output (rather than between the capital stock and output). In this paper, a new investment equation is estimated in the full structural framework, exploiting a measure of the capital stock constructed by the Bank, and a long series for the cost of capital. A CES production function is assumed, and a well-determined estimate of the elasticity of substitution is obtained by a variety of measures. The robust result is that the elasticity of substitution is significantly different from unity (the Cobb-Douglas case), at about 0.45. Overidentifying restrictions on the long-run relationship are all accepted. Although the key long-run parameter (the elasticity of substitution) is highly robust to alternative specifications, single-equation investment relationships may obscure the dynamics. There is evidence that the Johansen method is oversized, but given this, a test for excluding the capital accumulation identity from the investment equation is much better than using a single-equation ECM.

Suggested Citation

  • Colin Ellis & Simon Price, 2003. "UK business investment: long-run elasticities and short-run dynamics," Bank of England working papers 196, Bank of England.
  • Handle: RePEc:boe:boeewp:196
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    References listed on IDEAS

    as
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    Cited by:

    1. Björn A. Hauksson, 2005. "Aggregate business fixed investment," Economics wp27_bjorn, Department of Economics, Central bank of Iceland.
    2. Lydon, Reamonn & Scally, John, 2014. "Trends in Business Investment," Quarterly Bulletin Articles, Central Bank of Ireland, pages 76-89, January.
    3. Stephen Millard & John Power, 2004. "The effects of stock market movements on consumption and investment: does the shock matter?," Bank of England working papers 236, Bank of England.
    4. Smith, James, 2008. "That elusive elasticity and the ubiquitous bias: Is panel data a panacea?," Journal of Macroeconomics, Elsevier, vol. 30(2), pages 760-779, June.
    5. Simon Price, 2004. "UK investment and the return to equity: Q redux," Money Macro and Finance (MMF) Research Group Conference 2004 87, Money Macro and Finance Research Group.

    More about this item

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity

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