Government Investment and the Stock Market

Abstract:     
High rates of government investment in public sector capital forecast high risk premiums both at the aggregate and firm-level. This result is in sharp contrast with the well-documented negative relationship between the private sector investment rate and risk premiums. To explain the empirical findings, we extend the neoclassical q-theory model of investment and specify public sector capital as an additional input in the firm’s technology. We show that the model can quantitatively replicate the empirical facts with reasonable parameter values if public sector capital increases the marginal productivity of private inputs.

Number of Pages in PDF File: 39

Keywords: q-theory, public sector capital, return predictability

JEL Classification: G12, E62, H41, G28

working papers series