Estimating the Long-Run User Cost Elasticity

Abstract

The user cost elasticity is a parameter of central importance in economics, with implications for monetary policy, macroeconomic models, tax policy, growth and many other areas. If the supply curve for capital is upward sloping and shocks to demand area important (as they are likely to be over the business cycle), estimates of the user cost elasticity that rely on high-frequency movements in the variables will tend to be biased. This paper applies cointegration techniques to a small, open economy. The combination of exogeneity of user cost implied by the flat supply of capital curve for a small, open economy and appropriate correction for small sample bias yields an estimate of the long-run user cost elasticity which is about 75% larger (in absolute value) than the best existing estimate. In addition, the paper makes three further contributions: accounting for increases in depreciation (due to dramatic increases in computer use), estimating the long-run user cost elasticity for structures and the total capital stock, and disentangling the effects of capital goods prices, the real interest rate, and taxes.