Arnold Kling

Stuck in the q

Arnold Kling, Great Questions of Economics
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This article in Business Week Online explains the weak performance of the high tech sector.

...corporate customers account for 84% of tech spending. And businesses have yet to pry open their wallets.

...overall information-technology spending by business is 11% below year-ago levels.

Often, the business press is focused almost entirely on what consumers are doing. However, business investment can be the most significant cyclical component in the economy.

I believe that James Tobin's "q-theory" explains investment very well. Tobin says that when the ratio of the market value of corporate assets to their replacement cost is high, firms try to add to their assets by increasing investment.

Tobin's q is the ratio of market value to replacement cost. Stock market valuation is in the numerator, and the cost of capital goods is in the denominator. (I'm leaving out some other elements.)

I believe that a major channel by which the stock market affects the economy is through Tobin's q and its impact on business investment. For example, during the Internet bubble, q was particularly high for companies in the dotcom and telecommunications industries, leading to heavy investment in computers and communications equipment. Since then, q has plummeted in those sectors, driving investment way down.

Discussion Question. Brad DeLong recently told me that he left Tobin's q out of his Macroeconomics textbook because he thinks that it is too complicated a concept. Is q beyond comprehension for a student of introductory economics?

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