An Evaluation of Alternative Investment Hypotheses Using Non-Nested Tests

Abstract

Investment is an important determinant of aggregate economic performance in most macroeconomic models. There are, however, quite different hypotheses about the determinants of aggregate investment behavior. Several studies have evaluated the performance of alternative investment models based upon explanatory power and/or predictive ability.' A survey of the results of these studies reveals that, depending on the time period used for the evaluation, and the type of investment spending, the preferred models vary between studies. Unlike previous studies, we evaluate alternative econometric investment models utilizing hypothesis tests based on a structural norm. Because of differences in the theoretical foundations for the investment hypotheses, empirical specifications used for evaluating these hypotheses with available data are non-nested; i.e., the alternative specifications cannot be viewed as special cases of one another. Strictly speaking, the criterion of explanatory power is not correct when non-nested alternatives are being considered and the questions focus on comparative structural specifications. The choice of the most appropriate structure of econometric investment equations is important for two reasons. First, if one is interested in forecasting investment spending, a properly specified model will perform better over time than an improperly specified one. Confidence in model specification reduces the probability that the results are a statistical artifact or a result of spurious time series regressions [6, 202-204]. Second, if one is interested in evaluating the effects of policy changes on investment spending, model specification is crucial.2 Alternative specifications of investment equations have quite different implications for policy changes. For example, a change in the investment tax credit would have no direct impact in an accelerator model. This paper reports results from applying non-nested hypothesis tests to the evaluation of alternative investment models. The issue is which model specification is most appro-