Measurement error in the capital stock and its effect on the investment function

Abstract

Capital Stock variables appearing in investment and other equations are almost always constructed by the ‘perpetual inventory method’. A major problem with this method is that the initial real capital stock, K(0), that is implicitly a component of every measure of the capital stock, can rarely be measured with any degree of accuracy. It is shown that such measurement error can frequently lead to severe bias in the estimated coefficients of investment functions. This paper proposes a method to bypass this source of measurement error and illustrates its use with a practical application.