1991 Series • No. 91–8
Research Department Working Papers
Economic Rents, the Demand for Capital, and Financial Structure
The correspondence between the demand for capital and various measures of the return on assets, the cost of capital, and Tobin's q often is tenuous (Abel and Blanchard 1986; Hayashi 1982), at times even perverse. Of a variety of possible explanations, this paper considers the consequences of allowing for declining returns to capital--a declining marginal efficiency of capital schedule (MEC). This modification not only relaxes the connection between the demand for capital and many of its traditional determinants, but it also may introduce a connection among the value of the firm, its financial structure, and its stock of assets.