Capital Adjustment Costs Research Articles

Fiscal policy volatility and capital misallocation: Evidence from China

This paper investigates how domestic policy uncertainty stemming from discretionary fiscal policy disrupts efficient capital allocation across firms. While fiscal policy represents the government’s reaction to economic conditions, its volatility presents firms with considerable uncertainty about conditions affecting their future profitability and consequently disrupts decisions about investment in the presence of capital adjustment costs. Using firm-level data from Chinese manufacturing industries spanning from 1998 to 2007, we find that reducing fiscal policy volatility leads to a decrease in the dispersion of the marginal revenue product of capital, accounting for 8.3 percent of the observed improvement in capital allocation during the sample period. In addition to various fiscal reforms to curb fiscal policy volatility directly, policies contributing to lower capital adjustment costs and lower reliance of firms on government expenditure can alleviate the adverse effects of fiscal policy volatility.

Application of Dynamic Structural Model to Identify Factors That Influence Capital Adjustments in The National Manufacturing Industry

This research aims to determine the costs of capital adjustments and company dynamics. Company panels comprise the database. The main advantage of analyzing the nature of adjustment costs at the plant level is that the data contain information for purchases and sales of capital goods. Panel data, including information from many plants and long periods, allows for a more comprehensive analysis of firms' investment behavior in the face of capital adjustment costs. The estimation results allow for the recovery of companies' frictions in adjusting their capital stock. The estimation results for capital adjustment costs are consistent with other studies using similar methodologies. Estimates show that there are significant, unchangeable fixed costs, as well as moderate quadratic costs. Researchers then use the estimated parameters in a counterfactual simulation to analyze the impact of a decline in average firm profitability on the labor market. The results show a significant labor market response to the shock, with the transition to the new stable state being slow and taking several years to complete the adjustment. The simulations highlight the importance of not only modeling capital mobility but also considering and estimating its frictions to evaluate the impact of policies or shocks on the economy. The mobility and capital adjustment costs influence the speed of the economy's adjustment to shocks and their effects on factor allocation and remuneration in the short and long term.

Asset-Based Microfinance for Microenterprises: Evidence from Pakistan

We run a field experiment offering graduated microcredit clients the opportunity to finance a business asset worth four times their usual borrowing limit. We implement this using a hire-purchase contract; our control group is offered a zero interest loan at the usual borrowing limit. We find large, significant, and persistent effects: treated microenterprise owners run larger businesses with higher profits; consequently, household consumption increases, particularly on food and children’s education. A dynamic structural model with nonconvex capital adjustment costs rationalizes our results and allows counterfactual analysis; this highlights the potential for welfare improvements through large capital injections that are financially sustainable. (JEL C93, D22, G21, G32, L25, O14, O16)

Islamic banks and capital buffer behavior: A view from the Gulf cooperation council markets

This study explores the determinants of the capital buffer behavior (CB) of Islamic banks (IBs) using a sample of 42 IBs in the Gulf Cooperation Council (GCC) markets during 2009–2018. We also investigate the transmission mechanism, efficacy of the macroprudential policies, relationships between these policies, and financial stability of these banks. Unlike previous research, this study considers certain peculiarities of IBs, including the effects of profit–loss-sharing investment accounts (PSIAs); the impact of capital adjustment costs; external factors such as market power and competition; and institutional influences such as the rule of law and the potential corruption perceptions index. Overall, our results show that CB is countercyclical, which is in line with Basel III requirements. Furthermore, CB is positively affected by bank size, level of profitability, and competition and negatively impacted by nonperforming loans, credit risk, and displaced commercial risk (DCR). The regulatory determinants are important as well, suggesting that strengthening the official macroprudential supervision encourages banks to strengthen their CBs. Conversely, although banks have adequate capital, regulatory tools increase the burden, increasing banks' capital costs and forcing them to limit risk-weighted asset expansion and credit growth. Furthermore, the regulatory pressure, proxied by a discretionary countercyclical buffer, is not binding and does not increase CBs as they are already moving countercyclically, making macroprudential tools redundant for IBs. Other important implications suggest that IBs do not require additional CBs to cover the DCR associated with PSIAs, as PSIAs' provisions, profit equalization reserves, and investment risk reserves already cover this risk. Additionally, the positive relationship between IB size and CB might indicate that the “too big to fail” hypothesis does not apply to large IBs in the GCC.

Can Capital Adjustment Costs Explain the Decline in Investment–Cash Flow Sensitivity?

AbstractIt is well documented that since at least the 1970s investment-cash flow (I-CF) sensitivity has been decreasing over time to disappear almost completely by the late 2000s. Based on a neoclassical investment model with costly external financing, we show that this pattern can be explained by the gradual increase of capital adjustment costs, attributable to the accumulation of knowledge capital. The result is robust to a variety of approaches, including Euler equation estimation and the simulated method of moments. More generally, our findings demonstrate that I-CF sensitivity should only be interpreted as a joint measure of financial and real frictions.

SOEs reform and capital efficiency in China: A structural analysis

This paper investigates the effect of state-owned enterprises reform, a policy phrased as “grasping the large, letting the small go”, on firms’ capital efficiency in Chinese industries from 1998–2007. First, we present several stylized facts on investment rates in state and private firms. Second, a dynamic programming problem is proposed and key structural parameters are recovered through simulated moment matching method, so the estimated dynamic model is able to replicate the stylized facts that are directly observable from the firm-level data. Our quantitative analysis shows that the conversion of state firms into private ones reduces capital adjustment costs. Particularly, state firms’ quadratic adjustment cost declines significantly almost by half, and the fixed cost decreases slightly. These findings are robust in various specifications. Hence, the reform in state firms leads to increased capital efficiency. Last, the counterfactual analysis suggests that state and private firm’s output would increase about 9.60% and 1.87% if the capital adjustment costs in state firms were lowered to the same levels in private firms.

Yield curve and the macroeconomy: Evidence from a DSGE model with housing

The slope of the yield curve has long been found to be a useful predictor of future economic activities, but the relationship is unstable. One change we have identified in this paper is that, between the early 1990s and the collapse of the housing market in 2007, movements at the long end of the yield curve have an increase in predictive power. We use a medium-scale DSGE model with a housing sector and a yield curve as a guide to find out the sources of such change. The model implies that an increase in the short-term interest rate and a decrease in the long-term interest rate have different impacts on the economy, and to use the slope as a predictor one needs to distinguish movements at the two ends of the yield curve. Based on simulated data from the model, we find that nominal wage rigidities and the capital adjustment costs are closely related to the predictive power of the yield curve. This result is further confirmed with actual data.

Explaining the decline in the US labor share: taxation and automation

This study provides evidence for the USA that the secular decline in the labor share is not only explained by technical change or globalization, but also by the dynamics of factor taxation, automation capital (robots), and population growth. First, we empirically find indications of co-integration for the period from the last quarter of the 20th to the first decade of the twenty-first century. Permanent effects on factor shares emanate from relative factor taxation. The latter also have a lasting effect on the use of robots. Variance decompositions reveal that taxing contributes to changes in the two income shares and in automation capital. Second, we analyze and calibrate a neoclassical growth model extended to include factor taxation, automation capital, and capital adjustment costs. Labor and automation capital are perfect substitutes, whereas labor and traditional capital are complements. The model replicates the dynamics of the observed functional income distribution in the USA during the 1965–2015 period. Counterfactual experiments suggest that the fall in the labor share would have been significantly smaller if labor and capital income tax rates had remained at their respective level of the 1960s.

A Note on nonconvex adjustment costs in lumpy investment models: Mean versus variance

AbstractThis paper revisits the canonical assumption of nonconvex capital adjustment costs in lumpy investment models as in Khan and Thomas [(2008) Econometrica 76(2), 395–436], which are assumed to follow a uniform distribution from zero to an upper bound, without distinguishing between the mean and the variance of the distribution. Unlike the usual claim that the upper bound stands for the size (represented by the mean) of a nonconvex cost, I show that in order to generate an empirically consistent interest elasticity of aggregate investment, both a sizable mean and a sizable variance are necessary. The mean governs the importance of the extensive margin in aggregate investment dynamics, while the variance governs how sensitive the extensive margin is to changes in the real interest rate. As a result, both the mean and the variance are quantitatively important for aggregate investment dynamics.

Explaining the Decline in the US Labor Share: Taxation and Automation

This study provides evidence for the US that the secular decline in the labor share is not only explained by technical change or globalization, but also by the dynamics of factor taxation, automation capital, and population growth. First, we empirically find indications of co-integration for the 1974-2008 period. Permanent effects on factor shares emanate from relative factor taxation. The latter also have a lasting effect on the use of robots. Variance decompositions reveal that taxing contributes to changes in the two income shares and in automation capital. Second, we analyse and calibrate a neoclassical growth model extended to include factor taxation, automation capital, and capital adjustment costs. The model is able to replicate the dynamics of the observed functional income distribution in the US during the 1965-2015 period. Counterfactual experiments suggest that the fall in the labor share would have been significantly smaller if labor and capital income tax rates had remained at their respective level of the 1960s.

Risk matters: Breaking certainty equivalence in linear approximations

In this paper we use the property that certainty equivalence, as implied by a first-order approximation to the solution of stochastic discrete-time models, breaks in its equivalent continuous-time version. We derive a risk-sensitive first-order perturbation solution for a general class of rational expectations models. We show that risk matters economically in a real business cycle (RBC) model with habit formation and capital adjustment costs, and that neglecting risk leads to substantial pricing errors. A first-order perturbation provides a sensible approximation to the effects of risk in continuous-time models. It reduces pricing errors by around 90% relative to the certainty equivalent linear approximation.

The Dynamic Demand for Capital and Labor: Evidence from Chinese Industrial Firms

This paper employs a structural econometric approach to investigate the joint dynamic demand for capital and labor in Chinese industries from 1998-2007. First, we summarize several stylized facts on factor input adjustments, such as the mix of smooth and lumpy adjustments in capital and labor, and the interrelation in factor adjustments. Based on these facts, we then propose a dynamic model that incorporates the key features: fixed costs of installing capital and creating or discontinuing a job vacancy; convex costs aimed at capturing smooth adjustments; and inter-relational costs associated with joint adjustments in capital and labor. The structural parameters in capital and labor adjustment costs are recovered via simulated moment matching method, so the proposed dynamic model is able to reproduce the stylized facts that are directly observable from the Chinese firm-level data. Our structural estimations show: (1) firms prefer to make small adjustments in capital and labor simultaneously, and make large adjustments in two factors sequentially; (2) for both capital and labor, the convex adjustment cost is dominant comparing to the fixed cost; (3) ignoring labor adjustment costs leads to a larger bias than ignoring capital adjustment costs. The existence of joint adjustment costs indicates that reform in capital (labor) market will affect firm's demand in labor (capital) accordingly.

Investment dynamics and capital distortion: State and non-state firms in China

This paper studies investment dynamics in Chinese manufacturing firms. The analysis estimates capital adjustment costs and uncovers capital distortion in state and non-state firms. There is strong evidence of quadratic adjustment cost and distortion in capital price for both types of firms. The capital distortion is a major source of capital misallocation in Chinese firms. Completely removing the distortion would increase aggregate total factor productivity (TFP) by 18–29%.

Volatility, Adjustment Cost and Capital Misallocation: Evidence from Chinese Industrial Firms

This paper investigates the impact of volatility in profitability shock and capital adjustment cost on aggregate total factor productivity (TFP) in Chinese industries firms. To quantify the effects of volatility and adjustment costs on aggregate TFP, we recover key structural parameters in a dynamic optimization problem, so the model is able to replicate salient features observed from the firm-level data. Our result shows that volatility leads to considerable loss in aggregate TFP, while the role of adjustment cost is limited but significant.

Nonconvex Adjustment Cost in Lumpy Investment Models: Mean versus Variance

This paper revisits the canonical assumption of nonconvex capital adjustment costs in lumpy investment models as in Khan and Thomas (2008), which are assumed to follow a uniform distribution from zero to an upper bound, without distinguishing between the mean and the variance of the distribution. Unlike the usual claim that the upper bound stands for the size (represented by the mean) of a nonconvex cost, I show that in order to generate an empirically consistent interest elasticity of aggregate investment, both a sizable mean and a sizable variance are necessary. The mean governs the importance of the extensive margin in aggregate investment dynamics, while the variance governs how sensitive the extensive margin is to changes in the real interest rate. As a result, both the mean and the variance are quantitatively important for aggregate investment dynamics.

Labor Coordination and Division: Human Capital Investment in Supply Chains

We document a human capital coordination framework between supply chain partners. We show that the coordination between supply chain partners is much more intensive than firms who are potential but not actual supply chain partners, supporting the human capital as a relationship-specific investment in supply chains. The coordination is further enhanced for suppliers with higher R&D intensity, higher bargaining power, and lower human capital adjustment costs. We establish a causality claim using the H-1B lottery as an exogenous instrument variable to firms' human capital acquisition. By examining the detailed job occupations and demanded skills, we find that supply chain partners coordinate by hiring common and labor-intensive occupations and general skills while pursuing labor division for positions of specialized, technology-intensive occupations and specialized skills.

Asset-based microfinance for microenterprises: Evidence from Pakistan

We conduct a field experiment offering graduated microcredit clients the opportunity to finance a business asset worth four times their previous borrowing limit. We implement this using a hire purchase contract; our control group is offered a zero-interest loan. We find large, significant and persistent effects from asset finance contracts: treated microenterprise owners run larger businesses and enjoy higher profits; consequently, household consumption increases, particularly on food and children’s education. A dynamic structural model with non-convex capital adjustment costs rationalises our results; this highlights the potential for welfare improvements through large capital injections that are financially sustainable for microfinance institutions.

A Further Look at the Propagation of Monetary Policy Shocks in HANK

AbstractWe provide quantitative guidance on whether and to what extent different elements of Heterogeneous Agent New Keynesian (HANK) models amplify or dampen the response of aggregate consumption to a monetary policy shock. We emphasize four findings. First, the introduction of capital adjustment costs does not affect the aggregate response, but does change the transmission mechanism so that a larger share of indirect effects originates from equity prices rather than from labor income. Second, incorporating estimated unequal incidence functions for aggregate labor income fluctuations leads to either amplification or dampening, depending on the data and estimation methods. Third, distribution rules for monopoly profits that allocate a larger share to liquid assets lead to greater amplification. Fourth, assumptions about the fiscal reaction to a monetary policy shock have a stronger effect on the aggregate consumption response than any of the other three elements.

Yield Curve and the Macroeconomy: Evidence from a DSGE Model with Housing

The slope of the yield curve has long been found to be a useful predictor of future economic activity, but the relationship is unstable. One change we have identified in this paper is that, starting from the 1990s, movements at the long end of the yield curve have an increase in predictive power. We use a medium-scale DSGE model with a housing sector and a yield curve as a guide to find out the sources of such change. The model implies that an increase in the short-term interest rate and a decrease in the long-term interest rate have different impacts on the economy, and to use the slope as a predictor one needs to distinguish movements at the two ends of the yield curve. Based on simulated data from the model, we find that nominal wage rigidities and the capital adjustment costs are closely related to the predictive power of the yield curve. This result is further confirmed with actual data.

High-Dimensional Dynamic Stochastic Model Representation

We propose a generic and scalable method for computing global solutions of nonlinear, high-dimensional dynamic stochastic economic models. First, within an MPI–TBB parallel time-iteration framework, we approximate economic policy functions using an adaptive, high-dimensional model representation scheme, combined with adaptive sparse grids. With increasing dimensions, the number of points in this efficiently-chosen combination of low-dimensional grids grows much more slowly than standard tensor product grids, sparse grids, or even adaptive sparse grids. Moreover, the adaptivity within the individual component functions adds an additional layer of sparsity, since grid points are added only where they are most needed — that is to say, in regions of the computational domain with steep gradients or at non-differentiabilities. Second, we introduce a performant vectorization scheme of the interpolation compute kernel. Third, we validate our claims with numerical experiments conducted on “Piz Daint (Cray XC50) at the Swiss National Super-computing Center. We observe significant speedups over the state-of-the-art techniques, and almost ideal strong scaling up to at least 1, 000 compute nodes. Fourth, to demonstrate the broad applicability of our method, we compute global solutions to two different versions of a dynamic stochastic economic model: a high-dimensional international real business cycle model with capital adjustment costs, and with or without irreversible investment. We solve these models up to 300 continuous state variables globally.