Internal Net Worth and the Investment Process: an Application to U.S. Agriculture

48 Pages Posted: 2 Jul 2007 Last revised: 18 Aug 2022

See all articles by R. Glenn Hubbard

R. Glenn Hubbard

Columbia University - Columbia Business School, Finance; National Bureau of Economic Research (NBER)

Anil K. Kashyap

University of Chicago, Booth School of Business; National Bureau of Economic Research (NBER); Federal Reserve Bank of Chicago

Date Written: April 1990

Abstract

Recent models of firm investment decisions stressing informational imperfections in capital markets provide a foundation for interpreting evidence that movements in internal finance can predict investment opportunities. While such evidence is suggestive, it is often open to other interpretations. We present new evidence in favor of these models that addresses this gap in two ways. First, we focus on the U.S. agricultural sector; the sector has experienced large fluctuations in net worth and the profitability of investment, and reasonable measures of net worth can be constructed. Second, rather than relying on investment function representations (e.g., the q-theory approach), we make use of predictions generated by firms' Euler equation for capital accumulation. Intuitively, during periods in which net worth is high, the Euler equation should hold across adjacent periods; the equation will not hold for periods in which the shadow price of external finance is high because of low net worth. Such an approach offers an alternative model for periods in which internal net worth is low (holding constant investment opportunities), and generates a link between internal net worth and investment spending during periods of significant deflation in the value of net worth. Our empirical evidence is presented in three parts. First, the neoclassical, perfect-capital-markets model for investment is rejected by the data. Omitting periods during which there were substantial negative shocks to farmers' net equity positions, the model's overidentifying restrictions can no longer be rejected. Second, allowing for movements in net equity positions contributes importantly to explaining investment. Third, the effect of changes in net worth on investment is significantly more important during the deflationary periods than during "boom" periods. Taken together, these findings provide support for a class of "internal funds" models of investment under asymmetric information.

Suggested Citation

Hubbard, Robert Glenn and Kashyap, Anil K., Internal Net Worth and the Investment Process: an Application to U.S. Agriculture (April 1990). NBER Working Paper No. w3339, Available at SSRN: https://ssrn.com/abstract=468843

Robert Glenn Hubbard (Contact Author)

Columbia University - Columbia Business School, Finance ( email )

3022 Broadway
New York, NY 10027
United States

HOME PAGE: http://www.gsb.columbia.edu/faculty/ghubbard

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Anil K. Kashyap

University of Chicago, Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-702-7260 (Phone)
773 702-0458 (Fax)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States
773-702-7260 (Phone)
773-702-0458 (Fax)

Federal Reserve Bank of Chicago ( email )

230 South LaSalle Street
Chicago, IL 60604
United States