According to neoclassical growth theory, the capital stock is one of the main determinants of the long-run standard of living. In some versions of endogenous growth theory, the capital stock plays an even more important role by influencing the rate of economic growth.
According to standard economic theory, the long-run capital stock is determined by user cost. The quantitative magnitude of these effects is of crucial importance for many areas of economics, including monetary policy, business cycle models, tax policy, trade, economic development, and growth. Unfortunately, there is little consensus on the magnitude of these effects. For example, Chirinko (1993) concludes that “the response of investment to price variables tends to be small and unimportant relative to quantity variables,” while Hassett and Hubbard (2002) conclude that the user cost elasticity is probably between -0.5 and -1.
Caballero (1994, 1999) and Schaller (2006) argue that there are serious problems in obtaining unbiased estimates of user cost elasticity from short-run movements in investment, as the great majority of the previous literature has tried to do. Empirical researchers are trying to estimate the elasticity of the demand for capital, but the equilibrium quantity and price depend on both supply and demand. At business cycle frequencies, there are substantial movements in demand. If the supply curve for capital is upward sloping in the short run, as we believe most supply curves are, econometric methods that emphasize high-frequency fluctuations in the data will tend to pick up movements along this supply curve, biasing the elasticity estimate toward more positive values.
On the basis of these economic issues and their implications for the appropriate econometric techniques Caballero (1994, 1999) and Schaller (2006) argue that it will be possible to obtain better estimates of user cost elasticity by using low-frequency movements in the variables. To see this, note that shifts in the supply curve for capital are probably due primarily to technological change, which tends to have persistent effects on the price of investment goods and the real interest rate, and tax reforms, which also tend to be relatively persistent. This implies that techniques that emphasize low-frequency movements will tend to trace out points on the demand curve for capital while techniques that emphasize high-frequency movements are more likely to trace out points on the supply curve.
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Panel Cointegration Estimates of the User Cost Elasticity
