ROBERT E. HALL MassachusettsInstitute of Technology Investment, Interest Rates, and the Efects of Stabilization olicies THE RESPONSE of investmentexpenditure to changesin interestrates is at the heartof any analysisof stabilizationpolicy. The more sensitivethe response,the more potent is monetarypolicy and the weakeris fiscal ex- penditurepolicy. The stimulusof lowerinterest rates on investmentis one of the principalchannels of monetaryinfluence in virtuallyall macroeco- nomictheories. On the otherhand, the negativeinfluence of higherinterest rates on investmentmay inhibitthe macroeconomiceffect of expenditure policy. The net effect of governmentexpenditures on gross national producthas been and remainsthe single most importantsource of dis- agreementover stabilizationpolicy among economists.My purposehere is to examinethe empiricalevidence on the interestresponse of investment withthe hope of narrowingthe disagreementabout the effectsof expendi- ture and monetarypolicies. Thoughthe evidenceis disappointinglyweak, it does suggestthat the modem Keynesianview embodiedin large-scale macroeconometricmodels-that the expendituremultiplier is around1.5 -and the simple monetaristview-that it is essentiallyzero-are both incorrect.The most reasonablevalue lies in the middle, perhapsat 0.7. Unfortunately,the evidenceis probablynot strongenough to convincethe firmadherent of the othertwo positions. Note: This research was supported by the National Science Foundation. I am grateful to Dale W. Jorgenson and members of the Brookings panel for helpful comments. 61 62 BrookingsPapers on Economic Activity, 1:1977 The EmpiricalIssues The interestresponse of investmentdepends fundamentally on the sub- stitutabilityof capital for other factors, and there seems to be general agreementtoday that factor substitutioncan take place. In fact, the uni- tary-elasticityproperty of the Cobb-Douglasproduction function is not a bad summaryof the findinigsof more generalstudies: a decline of 1 per- cent in the serviceprice of capitalraises the capital-outputratio by about 1 percent.But this is a long-runrelationship, and it is muchless generally agreedthat the flow that bringsabout the changein the capitalintensity- extra investment-is highly responsiveto changesin the price of capital over the one- to three-yearhorizon of chief concern in stabilization. Skeptics about the interest elasticity of investmentpoint to three con- siderationsthat cause the adjustmentin factor intensitiesto take place slowly: 1. Lags in putting capital goods in place. It can take at least a year to design,order, build, and install capital equipment after a changein relative factorprices makes new equipmentdesirable. 2. The putty-clay hypothesis. Capital already in place cannot be adaptedto a differentcapital intensity; factor proportions are fixed at the time the equipmentis designed.Changes in factor intensitiesdictated by changesin the priceof capitaltake place only as the old capitalis replaced. 3. The term structure of interest rates. Stabilization policies affect the short-terminterest rate, but investmentresponds to the long-termrate. Longrates respond to shortrates with an importantlag. Evidencefrom a varietyof sources,discussed below, seemsto converge on the pointthat lags in the investmentprocess are long enoughto limit the immediateeffect of changesin the serviceprice of capitalon investment. The investmenttaking place in a given year is largelythe consequenceof irrevocabledecisions made in earlieryears, and only a small fractioncan be affectedby changesin that yearin the financialattractiveness of invest- ment.This considerationmakes expenditure policy strongerand monetary policy weaker than they would be in an economy with more flexibility aboutinvestment in the shortrun. Evidence on the putty-clayhypothesis is much more ambiguous.The paper containsa theoreticalexposition of the hypothesisthat emphasizes the centralissue with respectto its implicationsfor investmentbehavior: Robert E. Hall 63 Underputty-clay, firms do not face an economicdecision about how much output to produceon their existingcapital equipment.If there is such a decision-for example, if more output can be squeezed out of existing equipmentby operatingit for longerhours or addingmore labor in other ways-then the putty-clayhypothesis in its strict form is wrong and the response of investmentto the service price of capital is not just the change in the factor intensity of newly installed capacity but involves substitutionbetween new and old capitalas well. The paperdemonstrates a seriousproblem in the majorexisting attempt to measurethe influence of the putty-clayphenomenon in the investmentequation. No definite conclusionemerges about the importanceof putty-clay. The questionof the properinterest rate for an investmentequation is tackled only at the theoreticallevel. The simple argumentthat capital is long-livedand that consequentlythe investmentdecision should be based on the long-terminterest rate is examinedand confirmed, but this principle does not imply that the serviceprice of capitaldepends on the long rate. Rather,the serviceprice emergesfrom a comparisonof investmentdeci- sions madethis yearon the basisof this year'slong rate, andthose thatwill be made next year on the basis of next year'slong rate. This comparison involves the expectedchange in the long rate, which is measuredby the currentshort rate. As a matterof theory,it seems quiteunambiguous that an investmenttheory built aroundthe conceptof a serviceprice of capital shoulduse the shortrate. The prospectfor empiricalconfirmation of this principleseems slight, in view of the major difficultiesassociated with measurementof the role of interestrates of anykind. An EmpiricalIS-LM Framework Generationsof economists have been taught to study the effects of monetaryand fiscal policy within Hicks' IS-LM framework.In the dia- grambelow the IS curve traces the combinationsof the interestrate and real grossnational product that are consistentwith the expenditureside of the economy.Higher interest rates are associatedwith lower levels of GNP becauseof the negativeresponse of investment.The LM curve describes the alternativeinterest rates and levels of GNP that clear the money market.Higher levels of GNP requirehigher interestrates to clear the marketfor a given exogenousquantity of money. Increasedgovernment 64 BrookingsPapers onzEconomic Activity, 1:1977 expendituresshift the IS curveto the right,say to IS'. Real GNP rises from Y to Y'. The magnitudeof the increasedepends on the relativeslopes of the two curves:it is largeif the LM curveis flat and the IS curveis steep and small in the oppositecase. An increasedmoney supplyshifts the LM curveto the right,say to LM". Again, the effect on GNP dependson the relativeslopes of the two curves:monetary policy is potentif the IS curve is flatand the LM curveis steep. The centralquestion of this papercan be statedsuccinctly in the IS-LM framework:how flatis the IS curverelative to the LM curve?An algebraic developmentof the IS-LM model is a necessaryprelude to an empirical study.Start with a simpleconsumption function: C - o + 61Y, Interest rate LM LM LM"? _~~~~_ / ~ ~~~~~ is, f t I 5 y yP ytt ~~~RealGNP where C is consumption in real terms and Y is real GNP, and thus 0, is the marginal propensity to consume out of GNP. Next is the investment function, I I+ eY Y-72y; where I is real investmermtand r is the interestrate; GyN measures the ac- celeratoreffect of output on investmentand y2 is the crucialinterest re- Robert E. flail 65 sponse. The expenditureside of the economy is governedas well by the GNP identity, Y = C + I + GI where G is real governmentexpenditures. The IS curve is obtained by solvingthe threeequations for r as a functionof Y: r do + yo + G -(I - 01 - 1) Y 72 The finalequation is the money-demandfunction, M/p =-1'o + '1 Y - VI2r, whereM is the nominalmoney supply and p is the price level; 'P.is the incomeresponse of moneydemand and 2 iS the interestresponse. The LM curveis just the money-demandfunction solved for r: r- 0 + AY - M/p 'P2 The intersectionof the IS andLM curvesis obtainedby equatingthem and solvingfor Y: Y =o + I, G + g2 M/p, wherepu, is the effectof expenditureson GNP: 1 1-01 - 7Yl + IP (72/P2)' Note the crucialrole of the ratio of the two slope parameters,y2/'2. If the IS curveis steep and the LM curveis flat, y2/'2 is small and t,u is close to the simple Keynesian multiplier, 1/(1 - 0, - Yl). With a flat IS and a steep LM curve, 72/2 will be large, ,t will be small, and the interest-rate effectwill largelyoffset the simplemultiplier effect. The influenceof the realmoney supply is describedby2: rU=4 l + (- 01 - 7') (VP2/72)- Again, the ratio of the slope parameters,'P2/Y2, plays a centralrole, now in reciprocalform. If the IS curve is steep and the LM curveis flat, 'P2/y2 is largeand pt2is small. With a flat IS and a steep LM curve, the effect of monetaryexpansion on GNP will be close to the extreme value of the crudequantity theory, 1/'P,. How relevantis such a simplemodel to stabilizationpolicy in the mod- 66 BrookingsPapers on Economic Activity, 1:1977 em U.S. economy?In the firstplace, it takesthe real moneysupply, M/p, as predeterminedby monetarypolicy. Unless the monetaryauthorities offset every movementin prices, exogeneity of M/p is realistic only if pricesare takenas predetermined-thatis, if the pricelevel does not react to developmentsin the economy within the period.1This paper is con- cerned with the effect of stabilizationpolicy only for the first year after