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Tobin's Q and Asset Returns: Implications for Business Cycle Analysis

Posted: 26 Sep 2008  

Lawrence J. Christiano

Northwestern University; Federal Reserve Bank of Cleveland; Federal Reserve Bank of Chicago; Federal Reserve Bank of Minneapolis; National Bureau of Economic Research (NBER)

Jonas D. M. Fisher

Federal Reserve Bank of Chicago - Economic Research Department

Multiple version iconThere are 2 versions of this paper

Date Written: November 1, 1995

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.

Keywords: Asset prices, Equity premium, Tobin's q, Business cycle, Risk averson

JEL Classification: E32, D46

Suggested Citation

Christiano, Lawrence J. and Fisher, Jonas D. M., Tobin's Q and Asset Returns: Implications for Business Cycle Analysis (November 1, 1995). Available at SSRN: https://ssrn.com/abstract=1273267

Lawrence J. Christiano (Contact Author)

Northwestern University ( email )

2003 Sheridan Road
Evanston, IL 60208
United States
847-491-8231 (Phone)
847-491-7001 (Fax)

Federal Reserve Bank of Cleveland

East 6th & Superior
Cleveland, OH 44101-1387
United States

Federal Reserve Bank of Chicago

230 South LaSalle Street
Chicago, IL 60604
United States

Federal Reserve Bank of Minneapolis

90 Hennepin Avenue
Minneapolis, MN 55480
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Jonas D. M. Fisher

Federal Reserve Bank of Chicago - Economic Research Department ( email )

230 South LaSalle Street
Chicago, IL 60604-1413
United States

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