The Volatility of the Socially Optimal Level of Investment

In this paper an annual series for the socially optimal level of investment from 1960-61 to 1993-94 for Australia is derived from a vintage production function and compared to the actual series for investment over the same period. The vintage production function can be expected to yield a smoother socially optimal investment series than that derived from a non-vintage, malleable capital production function. Even so, the resulting series for socially optimal investment is much more volatile than the series for actual investment. Several alternative assumptions are tried in an attempt to further smooth the socially optimal investment series. These include smoothing the assumed values of the exogenous variables, modelling adjustment costs and delivery lags, and changing the form of the production function. While these approaches do succeed in smoothing the investment series, in order for the socially optimal investment series to be as smooth as the actual series the assumed values of the parameters must be quite unrealistic. In the conclusion we suggest that in future research on the socially optimal level of investment the role of liquidity constraints and of irreversible investment should be investigated.