Idiosyncratic Shocks and the Role of Nonconvexities in Plant and Aggregate Investment Dynamics

This 2008 Econometrica paper (circulated as NBER Working Paper 12845, January 2007) revisits whether “lumpy” plant-level investment – infrequent, large capital adjustments driven by nonconvex (fixed) adjustment costs – matters for aggregate investment dynamics, building a dynamic stochastic general equilibrium model in which establishments face both aggregate and persistent plant-specific productivity shocks, pay a random fixed cost to make large capital adjustments, but can also make small adjustments exempt from that cost. This combination of idiosyncratic productivity heterogeneity and a “free” low-level adjustment region makes the paper, in the authors’ words, “the first model consistent with available evidence on establishment-level investment rates” – correcting a key failure of the authors’ own earlier (2003) model, which could only match the data’s frequency of extreme investment episodes (“spikes”) by drastically overstating how often plants made no investment at all. Having matched the microeconomic data, the paper’s central finding echoes and extends the authors’ 2003 result: in partial equilibrium (with factor prices held fixed), nonconvex costs generate strong aggregate nonlinearities – large asymmetric swings in aggregate investment following positive versus negative shocks – but these nonlinearities are “quantitatively irrelevant” once the model is solved in general equilibrium, because market-clearing movements in the real wage and interest rate sharply dampen the swings in plants’ target capital stocks that would otherwise synchronize many plants’ adjustment decisions. A further, more surprising finding is that once plant-specific productivity shocks (calibrated to match the data) are present, nonconvex adjustment costs do not create investment spikes at all – a frictionless model with only idiosyncratic shocks already generates (and in fact overproduces) spikes – but instead eliminate some of them, reversing the role the lumpy-investment literature had traditionally assigned to these costs.

Aubhik Khan | Macro Paper Warehouse

Idiosyncratic Shocks and the Role of Nonconvexities in Plant and Aggregate Investment Dynamics