The Rise and Fall of Investment: Rethinking Q theory in Equilibrium

Abstract

The classic Q theory of investment is commonly interpreted to assert that marginal Q, synonymous to the marginal value of capital, is the sufficient statistic for investment. That is because Q-theory is purely demand-based in the sense that variations in investment are fully driven by those in the demand for investment.
This paper provides an exposition of how shocks to the supply of investment drive the joint dynamics of investment and Q. In absence of shocks to the marginal cost of investment (i.e., the supply of investment), shocks to the marginal value of investment (i.e., the demand for investment) determine both equilibrium investment and Q, resulting in a conventionally expected monotonic relation along the constant upward-sloping investment supply curve. In presence of non-trivial shocks to the marginal cost of investment, however, there is no longer a one-to-one relation between investment and Q. In essence, Q is to investment as price is to quantity in any demand-supply system. This paper theoretically demonstrates that, in a general dynamic model of investment, shocks to the investment demand induce a positive comovement between investment and Q when the marginal cost of investment is monotonically increasing, while shocks to the investment supply induce a negative comovement of investment and Q when investment is sufficiently inelastic to supply shocks. The elasticity of investment to demand and supply shocks critically depends on their respective persistence. This paper shows with numerical simulations that the correlation between investment and marginal/average Q critically depends on the relative volatility of and the persistence of supply shocks. A modest level of volatility of supply shocks is able to generate low or even negative correlations between investment and Q.
In summary, one should rethink from an equilibrium view the relation between investment and Q, both of which are simultaneously determined by shocks to both investment demand and supply.

Keywords: Investment, Q theory, investment demand and supply, adjustment cost

JEL Classification: E22, G31