2. Literature Review
2.1. Interest Rates and Investment
machines would decrease the price, the complexities of empirical macroeconomic conditions in relation to CEPs, ECDPs, or GMPs is difficult to pin down to a simple few number of variables.
Because of this, more complex models are likely required in order to more accurately understand their fluctuations. Interest rates for example are traditionally viewed as the cost of capital. This is still true, but only to a certain extent. Clearly, GDP impacts many other economic indicators not underneath the umbrella of its core components. Traditionally, it is also viewed that input costs such as labor and commodities likely play a role in prices as well. However, the degree to which this is the case is up for debate as is the directionality of the relationship between these variables and the aforementioned variables of technology and GDP. Much more basic variables could play a role such as supply and demand, but it may be the case that investment is the most important factor of all. This literature review will then go over these different variables to assert what the academic literature and what theoretical foundations have to say about the relationship between capital prices and their correlates. Moreover, it will take into consideration what traditional theory has to say on the matter was well.
2.1. Interest Rates and Investment
As mentioned, neo-classical macroeconomic theory generally asserts that the price of any good or service is devised from the implied equilibrium of supply and demand of such goods or services. Specifically, the literature suggests that capital goods can be defined as, “the physical objects (factories, machines, apple trees) produced by inputs now and used to produce outputs in the future,” (Friedman, 2019, pg. 343). Fundamentally, the purchasing of a piece of machinery is an investment, but the price of the investment made is based on multiple variables. Primarily, this study is focused on the price of production and is therefore not concerned with a large market of
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equipment and machinery which is arbitraged. Nonetheless, traditional neo-Keynesian theoretical assumptions suppose that a firm’s decision to invest in a piece of machinery is predicated upon interest rates which, when lower, incentivize firms to investment and when higher to hold off on borrowing to invest. The reason why interest rates are so important theoretically as price determinants of capital is that they are fundamentally, at a theoretical level, assumed to be equal to the price of capital (Ibid., pg. 344). This is the case because monetary capital is either invested in physical capital (factories or machines) or savings. Therefore, in the long-run the cost of capital must be the interest rate either earning interest on savings or suffering from interest on borrowing and subsequent investing.
The empirical literature also suggests that interest rates are quite important in the movement of equipment prices. Monetary policy can be aimed at addressing the distortions of factor prices such as wages of manufacturing employees through interest rate adjustment (Giang and Feng, 2011, pg. 120). Additionally, interest rates were found to be statistically significant with capital investment (Fama and Gibbons, 1982). Moreover, a strong school of thought on monetary theory asserts that monetary policy can cause overall goods inflation if money supply expansion is larger than gross domestic product (GDP) (Bernanke and Blinder, 1988). Because of this, it stands to reason that monetary policy could also impact CEPs given the impact that the theoretical foundation suggests interest rates have. However, little research has focused on the impact of monetary policy specifically on the price of CEPs. Since this is the case, it is difficult to assert one way or another the degree to which monetary policy empirically impacts CEPs, but the literature generally asserts that there is a positive relationship between interest rates and capital prices (Goolsbee, 1998). On top of this, the primary theoretical foundation additionally asserts that interest rates may have a positive impact on CEPs since lower interest rates translate into lower
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correlated with investment and economic growth (Restuccia and Urrutia 2001; Jones 1994; Sarel 1995; Lee 1995; DeLong and Summers 1991). Indeed, the empirical record of cross-country analyses asserts that capital prices are more expensive in underdeveloped economies, less expensive in developing economies, and even more less expensive in developed economies (Aslan et al., 2019). Research suggests that around 50 percent of this relationship can be accounted by trade openness and the elasticity of labor productivity (Ibid.). Moreover, it has been argued that the decreasing of capital prices has spurred investment and not the other way around (Ibid.).However, the directionality of these relationships are under dispute as others have suggested that investment in capital markets impacts prices and not the other way around (Jones, 1994;
Wilhelmsson, and Wigren, 2009).
Models have suggested that higher levels of investment are correlated with higher levels of equipment prices (Kogan and Papanikolaou, 2014, pg. 711). On theoretical grounds though, this notion appears to be inconsistent with neo-Classical models which suggest that technological development would reduce equipment production prices since technological development should increase efficiency in production. Capital spending in the 1990s was in part due to due plummeting computer prices and a surge in technology equities (McCarthy, 2001, pg. 1). Research has also found that from 1870 to the 1990s, productivity growth has been positively correlated with investment in equipment (De Long, 1995). Investment in equipment has also been posited to be positively correlated with economic growth and that industrialization is driven by human capital accumulation (Temple and Voth, 1998). Moreover, investment in capital goods is negatively
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correlated with capital prices as has been demonstrated by recent research on the topic (Collins and Williamson, 2001). Since this is the case, this thesis posits that the relationship between investment in technology (proxied by the NASDAQ Composite) and CEPs is negative.