By Pengfei Wang and Yi Wen
Firm-level investment is lumpy and volatile but aggregate investment is much smoother and highly serially correlated. These different patterns of investment behavior have been viewed as indicating convex adjustment costs at the aggregate level but non-convex adjustment costs at the firm level. This paper shows that financial frictions in the form of collateralized borrowing at the firm level (Kiyotaki and Moore, 1997) can give rise to convex adjustment costs at the aggregate level yet at the same time generate lumpiness in plant-level investment. In particular, our model can (i) derive aggregate capital adjustment cost functions identical to those assumed by Hayashi (1982) and (ii) explain the weak empirical relationship between Tobin’s Q and plant-level investment. Although aggregate adjustment cost functions can be derived from microfoundations, they are subject to the Lucas critique because parameters in such functions may not be structural and policy invariant.
Capital adjustment cost functions are liberally used in business cycles models to reduce excessive investment volatility, yet little thought has been given to their specification. This paper should help in getting an appropriate specification from microfoundations. But, as the authors note, this is still a reduced form, and thus the specification and its calibration may need to change with policy or other states.