What Drives Marginal Q Fluctuations?

Abstract

Sharp swings in the shadow value of capital (marginal Q) characterize business cycle fluctuations. An important question is whether marginal Q fluctuates due to revisions in expected marginal profits or discount rates, and by how much of each. We infer marginal Q from the marginal cost of investment, derive a present-value relation, and conduct a VAR-based variance decomposition for marginal Q. We find that the bulk of fluctuations in marginal Q stems from expected investment return (discount rate) shocks. Yet, expected marginal profit shocks play a non-negligible role. Additionally, the entire variation of investment stems from discount rate shocks.

Keywords: Tobin's Q; Present-value model; Investment return; Variance decomposition; VAR implied predictability; Aggregation bias; Marginal profit of capital; Long-horizon regressions

JEL Classification: E22; E27; G10; G12; G17; G31