Hayashi meets Kiyotaki and Moore: A theory of capital adjustment costs

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 Tobinʼs Q and plant-level investment.

► Investment is lumpy at firm level but smooth and serially correlated at aggregate level.
► Convex capital adjustment costs (CAC) are the standard assumption to explain aggregate investment.
► However, CAC are inconsistent with firm-level investment.
► We show that financial frictions can simultaneously explain lumpy investment and CAC.
► We can also explain the weak empirical relationship between Tobinʼs Q and investment.