THE EFFECTS OF INFLATION AND INFLATION UNCERTAINTY ON BUSINESS INVESTMENT
RESPESS, THOMAS SANFORD, III
Doctor of Philosophy
Previous theoretical analysis suggests that by reducing the real value of depreciation deductions based on historic-cost asset prices, inflation reduces the incentive to purchase depreciable plant and equipment. This analysis also suggests that the negative effects of inflation on investment will be greater for equipment than structure, and will vary according to different initial assumptions about real interest rates and asset purchase prices. Further, previous arguments indicate that increases in inflation uncertainty lead to reductions in business investment, brought about by increased hurdle rates, greater planning costs, and an overall slower rate of economic activity. This research is designed to supply data necessary to evaluate the importance of these factors as determinants of investment demand. From the data provided in this dissertation, four basic conclusions are identified. First, the empirical evidence supports the hypothesis that the decline in the real value of depreciation deductions brough about by inflation leads to a decline in real business investment. The data suggests that such effects are substantial, and that failure to account for the interaction of inflation and historic cost depreciation leads to incorrect predictions of investment demand. Second, the evidence in this dissertation supports the hypothesis that inflation leads to a much greater decline in equipment than structures investment. This result persists over a wide range of assumed economic conditions, indicating that the recent shift in the composition of business investment toward equipment is not explained by increases in inflation. Third, the data also confirm the hypothesis that the effects of inflation and historic cost depreciation on investment will vary over time. Changes in investment brought about by changes in inflation are jointly determined with real interest rates and asset purchase prices, and proper measurement of such effects is critically dependent on additional economic variables. Finally, the evidence obtained by this research confirms the hypothesis that inflation uncertainty is a significant determinant of investment demand. Although these effects are much smaller than the measured effects of inflation and historic cost depreciation on investment, they are nevertheless significant to the explanation of recent business investment behavior.