The Other Half of Gross Investment: Replacement and Modernization Expenditures

D URING the past two decades, gross investment has on average been divided approximately equally between net capital accumulation and replacement. Because of its relation to economic growth, the process of net accumulation has received nearly all of the attention in the investment literature. However, gross investment is the important variable for aggregate demand and therefore for stabilization. Moreover, an understanding of the process of replacement and modernization investment is necessary for a correct analysis of expansion investment. Recent econometric studies of investment behavior, both those in the neoclassical tradition and of the flexible accelerator type, rely on the assumption that replacement investment (Ir) is proportional to the capital stock (K). In some studies, this assumption is used to estimate a replacement investment series by finding a constant proportional depreciation rate (8) which reconciles the gross investment during the period being studied with the capital stock at the starting and ending dates.' This replacement series is then subtracted from gross investment (Ig) to yield a net investment series (In) which serves as the dependent variable in the regression analysis. In other studies, gross investment is used as the dependent variable; the lagged capital stock is then added to the regressors and its coefficient is assumed to estimate the rate of depreciation. Common to both methods, however, is the assumption that the ratio of replacement investment to the capital stock is constant. This assumption has two important effects. First, it influences the estimated parameters of the net investment behavior. Second, it implies that gross investment can be explained and forecast by a simple mechanical "technological" rule once net investment behavior and the starting capital stock are given. As Jorgenson and Stephenson [131 have emphasized, induced replacement investment can be a very important part of the short-run demand effect of changes in the policy variables that influence the accumulation of net capital.2 The assumption that replacement investment is proportional to the capital stock has long been used in an ad hoc way. More recently, Jorgenson [12] has shown that renewal theory implies that, in the long run, if the capital stock is growing at a constant rate, replacement investment approaches a constant proportion of the capital stock, whatever the initial age distribution and replacement rates for individual types of capital goods. He has, moreover, gone further than previous investigators and tested aspects of this theory [Jorgenson and Stephenson, 14]. More specifically, in econometric studies of two-digit investment behavior with Ig as the dependent variable he included the lagged capital stock among the regressors and performed tests on the estimated coefficient, 8; First, he showed that the null hypothesis that Ir is not related to the capital stock (8 = 0) could be rejected at low levels of significance in fifteen of the eighteen industries studied. Second, he showed that the values of 8 obtained in this way were generally not appreciably different from the values which reconciled the change in capital stock with the net investment series. It is important to note that these tests do not establish that replacement investment is proportional to the capital stock. In particular, they do not imply rejection of the following alternative hypothesis: Replacement investment varies around some average nonzero level in a way which is systematically related to other short-run economic forces. This alternative hypothesis is also not contradicted by * We are grateful for comments from the participants in the Harvard econometrics seminar in the fall term of I969 and for partial financial support of this research by the National Science Foundation (Grant No. GS-2241). 'For a description of this method, see Jorgenson and Stephenson [14]. 2The notion of a constant depreciation rate also enters neoclassical investment theory in a quite different way; the depreciation rate (a) is a parameter in the user cost of capital. See, e.g., Jorgenson [111.