Real Investment, Capital Intensity and Interest Rates

Abstract

In a growing economy the cash flows from investment projects can be expected to be rising over time. In this paper we explore the interactions of growth and uncertainty of cash flows with variable capital intensity in the decision to invest. We derive simple replacements for the usual neoclassical optimal investment rules based on IRR or NPV. We show that the ability to vary capital intensity raises the specter of perverse responses of investment to interest rates. Variable capital intensity is a sufficient condition for the perverse responses that can occur when growth rates are high or uncertainty is high. An empirical analysis of a panel data set on residential investment in the 1980sconfirms the predictions of the model and finds that about 40% of the observations fall in the positive response region.

JEL Classification: D81, E22, G31