In the past, many Keynesian economists have endorsed a “Tobin effect” in asserting that inflation may stimulate investment by raising the yield of holding real capital relative to that of holding unproductive cash balances. Besides the theoretical inadequacy of Tobin’s two-asset model in analyzing the problem of portfolio substitutions, this view has also ignored what is proven to be the most devastating nature of inflation, namely, the close association of price volatility with price inflation. It has been increasingly evident that price volatility has been playing a crucial role in the recent slowdown of capital formation in the U. S.
Our study aims to verify empirically this investment effect of inflation in Taiwan. We first establish various statistical series to quantify price variation. These are then employed as additional explanatory variables in a typical Jorgensonian neoclassical investment function. Although a uniform negative effect has not been confirmed, our regression analysis does produce some very interesting results. Specifically, the effect of price fluctuations on investment is dependent upon the different stages of a business cycle. In times of prosperity, a rising price is quite harmless, and may even contribute to optimistic expectations on the part of businessmen. However, once the economy enters a recession, price variations become an element of uncertainty, making the already hesitant firms even more unwilling to commit funds to any long-term investment projects.
The policy implication of our study is quite straightforward. Policymakers should not be tempted by possible temporary desirable effects into deliberately finetuning the economy, since their efforts may turn sour during a business downturn, and subsequently offset whatever good might previously have been achieved. Unless the cyclical fluctuations can be brought fully under control, which is not likely, a hands-off policy is still the best policy for steady investment growth.
