Ellen R. McGrattan and Edward C. Prescott The T.S. Kim Memorial Seminar, September 14, 2006 Unmeasured Investment and the U.S. 1990s Hours Boom Ellen R. McGrattan and Edward C. Prescott Arizona State University and Federal Reserve Bank of Minneapolis

The U.S. 1990s Boom It is puzzling from the perspective of the standard growth model Because …

1990s Hours Boom Hours boomed but labor productivity did not.

Resolution of Puzzle: Unmeasured Investment Standard measurement and theory mask real economic story Economic output includes a lot of unmeasured investment Tech boom led to Very large increase in unmeasured investment Large increase in market hours Large increase in economic output Sizable increase in economic output per hour

Outline Show 1990s is puzzling for standard model Extend model to include intangible, which is not measured, capital investment Permit nonneutral technological change with respect to producing intangible capital and measured output Show there is no puzzle when the 1990s is viewed through the lens of this extended model

Show 1990s a puzzle for standard theory

Theory without Unmeasured Investment Stand-in household maximizes

Stand-in firm's technology Use BEA & CPS data to determine TFP path Compute perfect foresight equilibrium path given TFPs, tax rates, and populations

Predicted and Actual Per-Capita Hours Large deviation from theory! TFP increase small and taxes rose.

Something Important Is Missing … Our conjecture is unmeasured investment Observations leading to this conjecture

Profits Fell in the Boom Would predict high profits in the boom.

R&D and High Tech Sector Boomed Private business R&D increased much more than GDP in the 1990s Many new high tech firms – e.g., in Silicon Valley

Growth Model with Unmeasured Investment Household/business owners solve where subscript m/u denotes measured/unmeasured and q is a price

Technologies Technology 1 – producing goods and services Technology 2 – producing intangible capital Total stock of intangible used by producers and researchers

Two Types of Intangible Investment Expensed: capital owners finance with reduced profits Sweat: worker owners finance with uncompensated time Parameter has tax implications

Before Using the Extended Model Must Revise Data in Light of Theory

Starting Point: National Accounts NIPA INCOME NIPA PRODUCT Capital consumption Personal consumption Taxes on production Government consumption Compensation less sweat Government investment Profits less expensed Private tangible investment Net interest Net exports

Revised National Accounts TOTAL INCOME TOTAL PRODUCT Capital consumption Personal consumption Taxes on production Government consumption Compensation less sweat Government investment Profits less expensed Private tangible investment Net interest Net exports Capital gains Intangible investment

Revised National Accounts TOTAL INCOME TOTAL PRODUCT Capital consumption Personal consumption Taxes on production Government consumption Compensation Government investment Profits Private tangible investment Net interest Net exports Intangible investment

Two Additional Steps Construct sub accounts and hours for: Business: corporate and noncorporate Nonbusiness: households, government, nonprofits because business sector is relevant for our model Use BEA and CPS data to set parameters

Using the Model Find TFPs from observables Must use equilibrium conditions given unmeasured investment not observed As for previous analysis, do not use intertemporal marginal condition for tangible capital Compute perfect foresight equilibrium path given TFPs

Start with Sequences of TFPs With period t observations on NIPA products, total hours, tax rates Intratemporal marginal condition → sector hours Sector rental rates equated → sector tangible capital stocks Sector wage rates equated → intangible investment output Current observation and equilibrium conditions imply all inputs and outputs to the two production functions Except for intangible capital

Finding the path of intangible Capital Stock Begin with a steady state value for 1990 Intertemporal condition → Boundary condition is

Start out with 1990 tangible capital stock and 1990 implied intangible capital stock Given population, tax rates, and implied TFPs, computed perfect foresight equilibrium path Intertemporal marginal conditions for tangible capital investment never used as case in the standard model analysis Path could go way off

Implied Sectoral TFPs Which are very different from standard TFP measure estimated for US.

Observations in Close Conformity with Theory

Predicted and Actual Hours Predicts large increase in hours: consistent with US.

Predicted and Actual Business Labor Productivities Predicts below trend and then above at end of 1990s: consistent with US.

Predicted and Actual Tangible Investment Only a modest deviation in tangible investment.

Comparing Theory and NIPA Wages Income account statistics not used in determining implicit TFPs and intangible capital stocks Consequently this is a demanding test

Question Does model yield accurate predictions for NIPA compensation? To answer, Put a BEA accountant in model economy Accountant estimates household’s compensation as:

Predicted and Actual Business Compensation Theory and data match up surprisingly well!

Implications for Capital Gains We put Flow of Funds accountant in model Accountant computes capital gains on businesses This is another demanding and independent test

Compare FOF Gains to Change in Business Value Business value in t: which depends on value of intangible stock

U.S. Non-Real Estate Capital Gains Above-trend gains in late 1990s as implied by theory.

The 1990s in Light of Theory with Unmeasured Investment

Model: Total and Measured Output Large differences between accounting and economic measures due to intangible investment.

Net Intangible Investment Share of Total Output Bottom line: Intangible Investment was large in the 1990s! Too Big to Ignore!

Model: Total and Measured Business Labor Productivity Large differences between accounting and economic measures due to intangible investment.

Conclusions And, the 1990s boom The growth model with unmeasured investment accounts for a variety of macro observations Growth Business cycle phenomena Depressions Stock market And, the 1990s boom