Government Investment and the Stock Market

Abstract

High rates of government investment in public sector capital forecast high risk premiums both at the aggregate and firm-level. This result is in sharp contrast with the well-documented negative relationship between the private sector investment rate and risk premiums. To explain the empirical findings, we extend the neoclassical q-theory model of investment and specify public sector capital as an additional input in the firm’s technology. We show that the model can quantitatively replicate the empirical facts with reasonable parameter values if public sector capital increases the marginal productivity of private inputs.