May 1, 2007
This paper presents a putty-clay model of capital that proceeds from profit maximization to an analytic solution for aggregate investment that fits the data well. The key innovation is a production function in which a geometric average of the capital-labor ratio embedded in each unit of capital replaces the aggregate capital-labor ratio in the standard Cobb-Douglas production function. The accelerator in this model depends on the growth rate of output in excess of labor productivity at full employment, rather than on the growth rate of output alone as in previous work. Growth of labor hours at full employment is an important driver of investment. Expectations of faster productivity growth boost current investment. The effect of productivity growth on the real rate of return in steady state is smaller than in the traditional neoclassical model. Cash flow and restrictions implied by the neoclassical model are not significant when added to the estimating equations. The putty-clay assumption allows growth of the capital stock to be split into its capital-widening and capital-deepening components. The model explains the sharp rise in the gap between capital income and business fixed investment in the early 2000s.