Working Paper Series no. 81: Pitfalls in Investment Euler Equations

Abstract

This paper investigates three pitfalls concerning the test of the Euler equation facing quadratic adjustment costs and perfect capital markets on a large balanced panel data of 4025 french firms. First, the quadratic parameterization of adjustment costs is too restrictive, and power series approximations of adjustment costs are tested. Second, we isolate firms whose optimal Euler condition is not altered even in the presence of fixed adjustment costs. Third, we identify instruments which contribute to model failure via standard GMM\ tests. These methods point that financial instruments contribute to reject strongly the standard model, which shows that it is misspecified.

Jean-Bernard Chatelain and Jean-Christophe Teurlai
January 2001

Classification JEL : C23, D21, D92

Keywords : Investment, adjustment costs, financial constraints, generalized method of moments