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August 11, 1980
adjusted sample) were computed
excluding
these firms.
The outstanding
feature of the estimates
in table 1 is the clear shift in investment composition toward short-lived capital facilities
during the 1970s. Measured by the geometric
mean of the individual ratios, composition
in
1976-79 included 5.6 units (1972 dollars) of
machinery for each unit of structures.
This
was more than 40 percent higher than the
compositional
ratio of 3.9 that was characteristic of the 1970-73 period. Relative dispersion among ratios was about the same in the
two periods, suggesting a true shift in the
distribution
of ratios rather than simply
greater dissimilarities
among firms in the
post-recession period.
A similar but somewhat less pronounced
shift is indicated by the estimates from the
adjusted sample. When firms that experience
the highest variability of investment composition are excluded, the compositional
ratio in
1976-79 is nearly 30 percent higher than in
1970-73. Relative dispersion among the ratios
in the adjusted sample is lower in 1976-79.
The recession years of 1974-75 do not
appear out of line with a shift in investment
composition
during the decade, despite economic conditions that might be expected to
disrupt investment patterns. The greater relative dispersion during the recession may reflect the effect of more varied business
expectations
at this time, but the variability
seems confined to the firms excluded from
the adjusted sample.
What caused the shift in the composition
of investment?
Factors such as technology
and government
regulation
no doubt were
important, especially if the origins of changes
are traced back to the 1960s. Computer technology is an obvious technological
force in
the period that is likely to increase machinery
relative to structures.
Pollution regulations
appeared in the late 1960s, probably
with
with similar effect. While these developments
would exert continuing
influence on investment composition,
and help explain why a
firm's machinery/structures
ratio would be
higher in the 1970s than earlier, it is less clear
that they would account for sharp changes
during the 1970s. Economic conditions in the

1970s, however, were volatile. The economy
experienced the worst business recession since
the 1930s. Recurring
energy price shocks
after 1973 added to economic uncertainty.
Inflation was a persistent problem throughout the 1970s, and in the latter part of the
decade inflationary
pressures intensified.
Inflation stems from many sources and
is not represented
by proportional
increases
in all individual prices. Some prices rise faster
than others, and relative prices as well as the
price level change in an inflationary environment. Even if the overall rate of inflation
were correctly anticipated
by firms, changes
in relative prices could influence investment
and its composition
through adjustments
in
a firm's demand for factors of production.
Indeed, the composition
of investment could
change regardless of what happens to the
level of investment.
Suppose a firm's demand for capital (and
the level of investment)
is unaffected by relative price changes associated with inflation.
A direct incentive to reallocate investment
could still arise if the relative price of machinery versus structures
changes. Judging
only from price indexes (implicit deflators)
of capital goods, the price of structures rose
faster than the price of machinery
in the
1970s. This was true, however, throughout
the decade, and the relative price change in
favor of machinery
was greater in 1970-73
than in 1976-79. To the firm, of course, the
important
consideration
in an investment
decision is the increase in costs from acquisitions of capital facilities. This is measured by
the rental price of capital, which is a broader
concept than a price such as the implicit deflator. The rental price includes, in addition
to the price index, the effects of taxes, depreciation, interest rates, and the firm's financial
structure.
Although
rental prices may have
moved similarly to price indexes in the 1970s,
this is uncertain. The impairment of depreciation allowances by inflation may have been
greater for structures than machinery, especially in 1976-79.
Of course, relative price effects alter the
demand for capital compared with other factors of production
and change the level of
investment.
On balance, relative factor price

movements
in the late-1970s
probably depressed the level of investment
(retarded
investment growth) and induced firms to hire
more labor.J In addition, energy price shocks
after 1973 were incentives for firms to conserve on the use of energy. Even if the relative price of machinery versus structures were
unchanged,
a firm substituting
labor for capital and conserving on energy would probably
shift its investment composition
toward the
machinery
component.
Incoming
workers
would require, in the absence of expanding
investment, a larger proportion of investment
going to machinery. Rapidly increasing energy prices could well have contributed
to the
observed compositional
changes by shortening service lives of less-energy-efficient
machinery in the existing capital stock and thus
increasing the rate of machinery replacement
relative to structures.
Additional
problems arise if inflationary
pressures are not uniform over time. If variability in the rate of inflation results in a
smaller
likelihood
that
inflation
will be
correctly
anticipated,
a firm's uncertainty
about future prices rises. This uncertainty
may be transitory,
in the sense that any
errors in anticipating
the rate of inflation
will, over time, net out to zero. If so, no
long-run influence on the level or composition
of real investment would be associated with
misinterpreting
inflationary
pressures.
A
short-run effect could exist, and, if the variability of inflation increases with the rate of
inflation, as some studies show, expectational
errors may be reinforcing during periods of
high inflation rates.f

3. This is consistent with the macro evidence on investment and employment
growth cited above.
Once again, depreciation
is an important
channel through which the rental price of (total)
capital is increased during inflation, as are corporate tax rates and the firm's financial structure. For a technical analysis of these effects on
capital,
see M. Feldstein,
J. Green, and E.
Sheshinski,
"Intlation
and Taxes in a Growing
Economy
with Debt and Equity
Finance,"
Journal of Political Economy (April 1978, part
2), pp. S53-70.
4. See Edward Foster, "The Variability
of Inflation,"
Review of Economics and Statistics
(August 1978), pp, 345-50.

The rate of inflation in 1976-79 was, on
simple measures,
more variable as well as
higher than in the early 1970s. Greater uncertainty
about
prices in the post-recession
period
followed
increases
in uncertainty
already generated
by the recession, which
were causing
firms to re-examine
many
aspects of the way they conducted
business.
As uncertainty
increases, binding commitments
become
a less desirable
business
policy.
For a firm's investment
decision,
structures
represent a more binding commitment than machinery. The shift in the composition of investment in the 1970s thus may
have been in part a reaction, though perhaps
temporary,
to the uncertain economic conditions of the time.

Conclusions
A pronounced shift in investment toward
short-lived
machinery
occurred
during the
1970s. Although the sample of firms examined was small and restricted to three industry
groupings (and therefore
not representative
of the economy as a whole), this evidence is
consistent
with broader
tendencies
noted
elsewhere.f
The shift was not associated with
growing dissimilarities among firms, nor does
it seem to have been the result of sudden
changes in technology or other long-run determinants of investment composition.
It could
well have been part of the inflationary
environment and uncertain economic conditions
of the decade. Apart from the level of investment, the shift in composition
suggests that
capital processes were formed that contributed to relatively slow expansion of potential
output. It is possible, for example, that much
of the investment effort in the late-1970s was
directed at improving energy efficiency rather
than capacity or labor productivity.
Longerterm implications are difficult to identify and
depend to a high degree on whether the economic conditions of the 1970s continue into
the 1980s.

5. See Burton G. Malkiel, "Productivity-the
Problem Behind the Headlines,"
Harvard Business
Review (May/June 1979), pp. 82-3.

ECONOMIC
COMMENTARY
In this issue:

Shifts In the Composition of
Fixed Investment In the 1970s

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

Table 1

Shifts in the Composition
of Fixed Investment In the 1970s
by Roger H. Hinderliter

Roger Hinderliter is an economic advisor, Federal
ReserveBank of Cleveland.
The opinions stated herein are those of the
author and not necessarily those of the Federal
Reserve Bank of Cleveland or of the Board of Governors of the Federal ReserveSystem.

outlining the investment
problem and discussing some of the aspects important to its
solution, be included each year in the Economic Report of the President. 1
Slow investment
growth
is but one
troublesome
feature
of recent investment
behavior. Another
is the shift in the composition of investment that has accompanied
slower growth. The allocation of total investment in the economy between short-lived and
long-lived capital facilities (between machinery and structures)
has been weighted more
heavily toward short-lived capital since the
mid-1960s, and this change also seems to have
accelerated
in the late-1970s. The allocation
of investment between short-lived and longlived capital facilities is important because the
mix of different
capital goods materially
affects the productive
capital processes acquired from a given level of investment.
A
capital process may be viewed as the combination of short-lived and long-lived facilities
that generates
output.
For example,
two
lathes per 100 square feet of factory space
can produce 20 units of output per hour.2
Many combinations
are available (three or
1. See Economic Report of the President (GPO,
January 1980), pp, 136-47.
2. The distinction
in this hypothetical
example is
not fully adequate. Machinery and factory space
are built to precise specifications
embodying
avai lable technology,
and these specifications
(for example, the cutting spread of a particular
lathe) serve further to distinguish among capital
facilities.
In empirical economic analysis, it is
usually not possible to capture very precise differences.
Investment
is measured
by dollars
spent, and quantities
(capital facilities) can be
measured only by constant dollar equivalents.

of Investment

Composition

Unadjusted
Period of
estimate
1970-73
1974·75
1976-79
a.

In recent years, a relatively low rate of growth
of real business investment has troubled U.S.
economic performance.
Since the last trough
in economic activity in 1975, real investment
has grown at an average rate of about 6.5 percent a year, compared with about 8 percent
a year for the average of five previous business expansions. Although real GNP growth
also was somewhat slower than in past expansions, some slippage in the share of output
devoted to increasing and replacing productive facilities occurred over the past five years.
Moreover, increases in employment
(about 4
percent a year since 1975) have been stronger
than past experience, suggesting a movement
toward more labor-intensive operations in the
business community.
Viewed from the perspective
of the
economy
as a whole, slow investment
has
been widely associated with the problem of
declining productivity
growth. Correspondingly, recent investment
performance
is reo
lated to developments
reaching back to the
mid·1960s. Concern over investment height·
ened as declining productivity
growth continued during the 1970s and intensified as the
decade drew to a close. Raising the level of
investment to improve productivity
has become a major objective of economic policy.
The Humphrey-Hawkins
Act (Full Employment and Balanced Growth Act of 1978)
directs that an Investment
Policy Report,

Estimates

Average
composition
3.9
4.9
5.6

in the 1970sa

sample

Adjusted

Relative
dispersion
1.12
1.36
1.16

Average
composition
3.3
3.6
4.2

sample
Relative
dispersion
0.72
0.72
0.55

Data are drawn from a sample of firms in machinery and equipment
industries (SIC 35, 36, 37) headquartered
in the Fourth District. The sample is a 40 percent random drawing from an industrial data
base maintained for research. Real investment was obtained by deflating current dollar, machinery, and
structures
outlays by the appropriate
price deflator from national income estimates. The unadjusted
sample includes 19 firms whose total 1979 constant dollar investment outlays range from $0.8 million
to $116.8 million. The adjusted sample excludes five firms that exhibited extreme variability in the
composition
of investment.
Investment composition
is measured by the ratio of constant dollar machinery and equipment
outlays (excluding rentals) to constant dollar outlays for structures (excluding
construction
in progress). Average composition
is the geometric mean of the individual ratios for the
period indicated.
Relative dispersion
is measured by the coefficient
of variation (standard deviation
divided by the arithmetic mean) of the individual ratios.

SOURCE:
Securities and Exchange Commission,
Form TOoK, Annual Report Pursuant to Section 13 or
15(d) of The Securities Exchange Act of 1934, Schedule V, Property, Plant, and Equipment.
Price data are from the Department
of Commerce, National Income and Product Accounts, Survey of
Current Business (various issues).

four lathes could be placed within 100 square
feet of space), but not all processes are equally
efficient. Processes are changed through investment, but the over-utilization
of one type
of capital relative to another
(for example,
crowding too many lathes into a given space)
is likely to result in less productive processes;
incremental capacity would be lower than if
the same level of investment were allocated
differently.
Though recognized in studies of the productivity
problem
and in the Investment
Policy Report, compositional
changes within
the level of investment have been examined
less closely than investment growth. In particular, little attention
has been focused on
the allocation
practices of individual firms,
where
the investment
decision
is made.
Ultimately,
changes in investment composition in the economy
as a whole rest on
capital-budgeting
decisions of firms. For the
firm, the composition
of investment,
like the
level of investment,
is an economic decision
that reflects the influence of current economic
conditions
as well as lonqer-terrn

effects, such as technological
change. This
Economic Commentary examines the composition of investment,
independent
of the
level of investment,
during the 1970s. Data
are drawn from a small sample of machinery
and equipment
firms in the Fourth Federal
Reserve District (see table 1, footnote
a).
Investment
composition
for
a "typical
firm" is estimated
for the periods 1970-73
and 1976-79 and separately for the recession
years of 1974-75.

Composition

of Fixed Investment

A firm's capital stock comprises many
different types of productive facilities. Some
facilities
have relatively
long service lives,
while others are capable of economically
producing output over a shorter time span.
Structures
(new plant) generally
produce
over longer periods than machinery, although
this division is only a proxy for actual service
lives of capital facilities. Some machinery may
be productive
for a long period, and some
structures may be less durable than structures
in general and lonqer-Iived machines.

A capital process available to a firm combines short-lived and lone-lived capital facilities. As an illustration,
let
(1)

K

=

K/ + 2Ks,

where
K represents
a productive
capital
"unit," and K/ and Ks are the long-lived and
short-lived
components,
respectively.
Here,
short-lived and long-lived components
combine in the ratio of two-to-one
to form one
productive capital unit.
Investment
changes the capital stock.
Investment
is the acquisition
of new capital units to replace those that are economically worn out (replacement)
and also to add
to the existing stock (expansion).
Because
the service lives of the short-lived and longlived components
in a capital unit differ, the
composition
of replacement
investment will
be different
from the capital unit being
replaced, even if the compositional
ratio of
the unit is unchanged.
If, for example, shortlived capital facilities wear out steadily over
five years
and long-lived
facilities
have
service lives of ten years, replacement
of the
capital unit in the example above would require annual investment in the ratio of 4Ks/
1KJ. The composition
of investment
for
expansion
reflects current values of the factors that determine
the makeup of capital
units. If these conditions are constant, expansion in the ratio 2Ks/1 K/ is consistent
with
the illustration.
The composition
of fixed
investment
is determined
by weighting the
ratios of replacement
and expansion.
If, for
any level of fixed investment,
replacement
and expansion
each are 50 percent of the
total, the composition
of fixed investment in
the example here would be 3Ks/1K/.
A variety of forces lead to changes in the
composition
of fixed investment.
Over the
longer term, technological
progress plays an
important role in determining the service lives
of capital facilities. Improved technology increases the rate of replacement
and, if it
affects service lives of the short-lived
and
lonq-lived facilities disproportionately,
will
alter the composition
of investment for both
replacement
and expansion.
Government

policies such as those dealing with pollution
abatement contain incentives for reallocating
investment,
as do provisions of the tax code.
The investment
tax credit, until 1978, excluded structures.
Although
the exclusion
may have been less binding in practice than
the code would suggest, the tax credit still
favored a shift in investment
toward shortlived facilities. Economic conditions,
as reflected in relative prices (or rates of return)
on capital, uncertainty,and
businessexpectations, also feed back into a firm's investment
decision, affecting both the level and composition of total investment.

Investment Composition

in the 1970s

Investment
decisions are not likely to
generate a smooth flow of short-lived
and
long-lived facilities into the capital stock.
Investment
is "lumpy,"
in that, for example,
a factory is added or replaced at one time
rather than adjusted gradually by the 100square-foot
piece. Thus, investment composition will vary, and, in a single firm or even
a sample of similar firms for a single year,
measured composition
can deviate from the
characteristic
combination
of facilities. For
a sample of firms over several years, however,
the lumpiness of investment should be largely
smoothed,
and a representative
estimate of
investment composition
can be derived.
Estimates
of investment
composition
(machinery/structures
in constant dollars) are
presented in table 1. The estimates are calculated from a sample of 19 Fourth District
firms that are producers
of machinery
and
equipment.
Restricting
the sample to firms
in capital-goods
industries holds constant, in
a simple way, the capital intensity of manufacturing operations.
Because firm size (the
level of investment) does not obviously influence composition,
no size restrictions
were
imposed. Large manufacturers
do not necessari Iy employ different capital processes, only
more capital than small manufacturers.
For
some firms in the sample, investment
in
structures appeared especially lumpy, which
contributed
very low compositional
ratios
in "factory
building years" and very high
ratios in other years. Separate estimates (the

Table 1

Shifts in the Composition
of Fixed Investment In the 1970s
by Roger H. Hinderliter

Roger Hinderliter is an economic advisor, Federal
ReserveBank of Cleveland.
The opinions stated herein are those of the
author and not necessarily those of the Federal
Reserve Bank of Cleveland or of the Board of Governors of the Federal ReserveSystem.

outlining the investment
problem and discussing some of the aspects important to its
solution, be included each year in the Economic Report of the President. 1
Slow investment
growth
is but one
troublesome
feature
of recent investment
behavior. Another
is the shift in the composition of investment that has accompanied
slower growth. The allocation of total investment in the economy between short-lived and
long-lived capital facilities (between machinery and structures)
has been weighted more
heavily toward short-lived capital since the
mid-1960s, and this change also seems to have
accelerated
in the late-1970s. The allocation
of investment between short-lived and longlived capital facilities is important because the
mix of different
capital goods materially
affects the productive
capital processes acquired from a given level of investment.
A
capital process may be viewed as the combination of short-lived and long-lived facilities
that generates
output.
For example,
two
lathes per 100 square feet of factory space
can produce 20 units of output per hour.2
Many combinations
are available (three or
1. See Economic Report of the President (GPO,
January 1980), pp, 136-47.
2. The distinction
in this hypothetical
example is
not fully adequate. Machinery and factory space
are built to precise specifications
embodying
avai lable technology,
and these specifications
(for example, the cutting spread of a particular
lathe) serve further to distinguish among capital
facilities.
In empirical economic analysis, it is
usually not possible to capture very precise differences.
Investment
is measured
by dollars
spent, and quantities
(capital facilities) can be
measured only by constant dollar equivalents.

of Investment

Composition

Unadjusted
Period of
estimate
1970-73
1974·75
1976-79
a.

In recent years, a relatively low rate of growth
of real business investment has troubled U.S.
economic performance.
Since the last trough
in economic activity in 1975, real investment
has grown at an average rate of about 6.5 percent a year, compared with about 8 percent
a year for the average of five previous business expansions. Although real GNP growth
also was somewhat slower than in past expansions, some slippage in the share of output
devoted to increasing and replacing productive facilities occurred over the past five years.
Moreover, increases in employment
(about 4
percent a year since 1975) have been stronger
than past experience, suggesting a movement
toward more labor-intensive operations in the
business community.
Viewed from the perspective
of the
economy
as a whole, slow investment
has
been widely associated with the problem of
declining productivity
growth. Correspondingly, recent investment
performance
is reo
lated to developments
reaching back to the
mid·1960s. Concern over investment height·
ened as declining productivity
growth continued during the 1970s and intensified as the
decade drew to a close. Raising the level of
investment to improve productivity
has become a major objective of economic policy.
The Humphrey-Hawkins
Act (Full Employment and Balanced Growth Act of 1978)
directs that an Investment
Policy Report,

Estimates

Average
composition
3.9
4.9
5.6

in the 1970sa

sample

Adjusted

Relative
dispersion
1.12
1.36
1.16

Average
composition
3.3
3.6
4.2

sample
Relative
dispersion
0.72
0.72
0.55

Data are drawn from a sample of firms in machinery and equipment
industries (SIC 35, 36, 37) headquartered
in the Fourth District. The sample is a 40 percent random drawing from an industrial data
base maintained for research. Real investment was obtained by deflating current dollar, machinery, and
structures
outlays by the appropriate
price deflator from national income estimates. The unadjusted
sample includes 19 firms whose total 1979 constant dollar investment outlays range from $0.8 million
to $116.8 million. The adjusted sample excludes five firms that exhibited extreme variability in the
composition
of investment.
Investment composition
is measured by the ratio of constant dollar machinery and equipment
outlays (excluding rentals) to constant dollar outlays for structures (excluding
construction
in progress). Average composition
is the geometric mean of the individual ratios for the
period indicated.
Relative dispersion
is measured by the coefficient
of variation (standard deviation
divided by the arithmetic mean) of the individual ratios.

SOURCE:
Securities and Exchange Commission,
Form TOoK, Annual Report Pursuant to Section 13 or
15(d) of The Securities Exchange Act of 1934, Schedule V, Property, Plant, and Equipment.
Price data are from the Department
of Commerce, National Income and Product Accounts, Survey of
Current Business (various issues).

four lathes could be placed within 100 square
feet of space), but not all processes are equally
efficient. Processes are changed through investment, but the over-utilization
of one type
of capital relative to another
(for example,
crowding too many lathes into a given space)
is likely to result in less productive processes;
incremental capacity would be lower than if
the same level of investment were allocated
differently.
Though recognized in studies of the productivity
problem
and in the Investment
Policy Report, compositional
changes within
the level of investment have been examined
less closely than investment growth. In particular, little attention
has been focused on
the allocation
practices of individual firms,
where
the investment
decision
is made.
Ultimately,
changes in investment composition in the economy
as a whole rest on
capital-budgeting
decisions of firms. For the
firm, the composition
of investment,
like the
level of investment,
is an economic decision
that reflects the influence of current economic
conditions
as well as lonqer-terrn

effects, such as technological
change. This
Economic Commentary examines the composition of investment,
independent
of the
level of investment,
during the 1970s. Data
are drawn from a small sample of machinery
and equipment
firms in the Fourth Federal
Reserve District (see table 1, footnote
a).
Investment
composition
for
a "typical
firm" is estimated
for the periods 1970-73
and 1976-79 and separately for the recession
years of 1974-75.

Composition

of Fixed Investment

A firm's capital stock comprises many
different types of productive facilities. Some
facilities
have relatively
long service lives,
while others are capable of economically
producing output over a shorter time span.
Structures
(new plant) generally
produce
over longer periods than machinery, although
this division is only a proxy for actual service
lives of capital facilities. Some machinery may
be productive
for a long period, and some
structures may be less durable than structures
in general and lonqer-Iived machines.

A capital process available to a firm combines short-lived and lone-lived capital facilities. As an illustration,
let
(1)

K

=

K/ + 2Ks,

where
K represents
a productive
capital
"unit," and K/ and Ks are the long-lived and
short-lived
components,
respectively.
Here,
short-lived and long-lived components
combine in the ratio of two-to-one
to form one
productive capital unit.
Investment
changes the capital stock.
Investment
is the acquisition
of new capital units to replace those that are economically worn out (replacement)
and also to add
to the existing stock (expansion).
Because
the service lives of the short-lived and longlived components
in a capital unit differ, the
composition
of replacement
investment will
be different
from the capital unit being
replaced, even if the compositional
ratio of
the unit is unchanged.
If, for example, shortlived capital facilities wear out steadily over
five years
and long-lived
facilities
have
service lives of ten years, replacement
of the
capital unit in the example above would require annual investment in the ratio of 4Ks/
1KJ. The composition
of investment
for
expansion
reflects current values of the factors that determine
the makeup of capital
units. If these conditions are constant, expansion in the ratio 2Ks/1 K/ is consistent
with
the illustration.
The composition
of fixed
investment
is determined
by weighting the
ratios of replacement
and expansion.
If, for
any level of fixed investment,
replacement
and expansion
each are 50 percent of the
total, the composition
of fixed investment in
the example here would be 3Ks/1K/.
A variety of forces lead to changes in the
composition
of fixed investment.
Over the
longer term, technological
progress plays an
important role in determining the service lives
of capital facilities. Improved technology increases the rate of replacement
and, if it
affects service lives of the short-lived
and
lonq-lived facilities disproportionately,
will
alter the composition
of investment for both
replacement
and expansion.
Government

policies such as those dealing with pollution
abatement contain incentives for reallocating
investment,
as do provisions of the tax code.
The investment
tax credit, until 1978, excluded structures.
Although
the exclusion
may have been less binding in practice than
the code would suggest, the tax credit still
favored a shift in investment
toward shortlived facilities. Economic conditions,
as reflected in relative prices (or rates of return)
on capital, uncertainty,and
businessexpectations, also feed back into a firm's investment
decision, affecting both the level and composition of total investment.

Investment Composition

in the 1970s

Investment
decisions are not likely to
generate a smooth flow of short-lived
and
long-lived facilities into the capital stock.
Investment
is "lumpy,"
in that, for example,
a factory is added or replaced at one time
rather than adjusted gradually by the 100square-foot
piece. Thus, investment composition will vary, and, in a single firm or even
a sample of similar firms for a single year,
measured composition
can deviate from the
characteristic
combination
of facilities. For
a sample of firms over several years, however,
the lumpiness of investment should be largely
smoothed,
and a representative
estimate of
investment composition
can be derived.
Estimates
of investment
composition
(machinery/structures
in constant dollars) are
presented in table 1. The estimates are calculated from a sample of 19 Fourth District
firms that are producers
of machinery
and
equipment.
Restricting
the sample to firms
in capital-goods
industries holds constant, in
a simple way, the capital intensity of manufacturing operations.
Because firm size (the
level of investment) does not obviously influence composition,
no size restrictions
were
imposed. Large manufacturers
do not necessari Iy employ different capital processes, only
more capital than small manufacturers.
For
some firms in the sample, investment
in
structures appeared especially lumpy, which
contributed
very low compositional
ratios
in "factory
building years" and very high
ratios in other years. Separate estimates (the

Table 1

Shifts in the Composition
of Fixed Investment In the 1970s
by Roger H. Hinderliter

Roger Hinderliter is an economic advisor, Federal
ReserveBank of Cleveland.
The opinions stated herein are those of the
author and not necessarily those of the Federal
Reserve Bank of Cleveland or of the Board of Governors of the Federal ReserveSystem.

outlining the investment
problem and discussing some of the aspects important to its
solution, be included each year in the Economic Report of the President. 1
Slow investment
growth
is but one
troublesome
feature
of recent investment
behavior. Another
is the shift in the composition of investment that has accompanied
slower growth. The allocation of total investment in the economy between short-lived and
long-lived capital facilities (between machinery and structures)
has been weighted more
heavily toward short-lived capital since the
mid-1960s, and this change also seems to have
accelerated
in the late-1970s. The allocation
of investment between short-lived and longlived capital facilities is important because the
mix of different
capital goods materially
affects the productive
capital processes acquired from a given level of investment.
A
capital process may be viewed as the combination of short-lived and long-lived facilities
that generates
output.
For example,
two
lathes per 100 square feet of factory space
can produce 20 units of output per hour.2
Many combinations
are available (three or
1. See Economic Report of the President (GPO,
January 1980), pp, 136-47.
2. The distinction
in this hypothetical
example is
not fully adequate. Machinery and factory space
are built to precise specifications
embodying
avai lable technology,
and these specifications
(for example, the cutting spread of a particular
lathe) serve further to distinguish among capital
facilities.
In empirical economic analysis, it is
usually not possible to capture very precise differences.
Investment
is measured
by dollars
spent, and quantities
(capital facilities) can be
measured only by constant dollar equivalents.

of Investment

Composition

Unadjusted
Period of
estimate
1970-73
1974·75
1976-79
a.

In recent years, a relatively low rate of growth
of real business investment has troubled U.S.
economic performance.
Since the last trough
in economic activity in 1975, real investment
has grown at an average rate of about 6.5 percent a year, compared with about 8 percent
a year for the average of five previous business expansions. Although real GNP growth
also was somewhat slower than in past expansions, some slippage in the share of output
devoted to increasing and replacing productive facilities occurred over the past five years.
Moreover, increases in employment
(about 4
percent a year since 1975) have been stronger
than past experience, suggesting a movement
toward more labor-intensive operations in the
business community.
Viewed from the perspective
of the
economy
as a whole, slow investment
has
been widely associated with the problem of
declining productivity
growth. Correspondingly, recent investment
performance
is reo
lated to developments
reaching back to the
mid·1960s. Concern over investment height·
ened as declining productivity
growth continued during the 1970s and intensified as the
decade drew to a close. Raising the level of
investment to improve productivity
has become a major objective of economic policy.
The Humphrey-Hawkins
Act (Full Employment and Balanced Growth Act of 1978)
directs that an Investment
Policy Report,

Estimates

Average
composition
3.9
4.9
5.6

in the 1970sa

sample

Adjusted

Relative
dispersion
1.12
1.36
1.16

Average
composition
3.3
3.6
4.2

sample
Relative
dispersion
0.72
0.72
0.55

Data are drawn from a sample of firms in machinery and equipment
industries (SIC 35, 36, 37) headquartered
in the Fourth District. The sample is a 40 percent random drawing from an industrial data
base maintained for research. Real investment was obtained by deflating current dollar, machinery, and
structures
outlays by the appropriate
price deflator from national income estimates. The unadjusted
sample includes 19 firms whose total 1979 constant dollar investment outlays range from $0.8 million
to $116.8 million. The adjusted sample excludes five firms that exhibited extreme variability in the
composition
of investment.
Investment composition
is measured by the ratio of constant dollar machinery and equipment
outlays (excluding rentals) to constant dollar outlays for structures (excluding
construction
in progress). Average composition
is the geometric mean of the individual ratios for the
period indicated.
Relative dispersion
is measured by the coefficient
of variation (standard deviation
divided by the arithmetic mean) of the individual ratios.

SOURCE:
Securities and Exchange Commission,
Form TOoK, Annual Report Pursuant to Section 13 or
15(d) of The Securities Exchange Act of 1934, Schedule V, Property, Plant, and Equipment.
Price data are from the Department
of Commerce, National Income and Product Accounts, Survey of
Current Business (various issues).

four lathes could be placed within 100 square
feet of space), but not all processes are equally
efficient. Processes are changed through investment, but the over-utilization
of one type
of capital relative to another
(for example,
crowding too many lathes into a given space)
is likely to result in less productive processes;
incremental capacity would be lower than if
the same level of investment were allocated
differently.
Though recognized in studies of the productivity
problem
and in the Investment
Policy Report, compositional
changes within
the level of investment have been examined
less closely than investment growth. In particular, little attention
has been focused on
the allocation
practices of individual firms,
where
the investment
decision
is made.
Ultimately,
changes in investment composition in the economy
as a whole rest on
capital-budgeting
decisions of firms. For the
firm, the composition
of investment,
like the
level of investment,
is an economic decision
that reflects the influence of current economic
conditions
as well as lonqer-terrn

effects, such as technological
change. This
Economic Commentary examines the composition of investment,
independent
of the
level of investment,
during the 1970s. Data
are drawn from a small sample of machinery
and equipment
firms in the Fourth Federal
Reserve District (see table 1, footnote
a).
Investment
composition
for
a "typical
firm" is estimated
for the periods 1970-73
and 1976-79 and separately for the recession
years of 1974-75.

Composition

of Fixed Investment

A firm's capital stock comprises many
different types of productive facilities. Some
facilities
have relatively
long service lives,
while others are capable of economically
producing output over a shorter time span.
Structures
(new plant) generally
produce
over longer periods than machinery, although
this division is only a proxy for actual service
lives of capital facilities. Some machinery may
be productive
for a long period, and some
structures may be less durable than structures
in general and lonqer-Iived machines.

A capital process available to a firm combines short-lived and lone-lived capital facilities. As an illustration,
let
(1)

K

=

K/ + 2Ks,

where
K represents
a productive
capital
"unit," and K/ and Ks are the long-lived and
short-lived
components,
respectively.
Here,
short-lived and long-lived components
combine in the ratio of two-to-one
to form one
productive capital unit.
Investment
changes the capital stock.
Investment
is the acquisition
of new capital units to replace those that are economically worn out (replacement)
and also to add
to the existing stock (expansion).
Because
the service lives of the short-lived and longlived components
in a capital unit differ, the
composition
of replacement
investment will
be different
from the capital unit being
replaced, even if the compositional
ratio of
the unit is unchanged.
If, for example, shortlived capital facilities wear out steadily over
five years
and long-lived
facilities
have
service lives of ten years, replacement
of the
capital unit in the example above would require annual investment in the ratio of 4Ks/
1KJ. The composition
of investment
for
expansion
reflects current values of the factors that determine
the makeup of capital
units. If these conditions are constant, expansion in the ratio 2Ks/1 K/ is consistent
with
the illustration.
The composition
of fixed
investment
is determined
by weighting the
ratios of replacement
and expansion.
If, for
any level of fixed investment,
replacement
and expansion
each are 50 percent of the
total, the composition
of fixed investment in
the example here would be 3Ks/1K/.
A variety of forces lead to changes in the
composition
of fixed investment.
Over the
longer term, technological
progress plays an
important role in determining the service lives
of capital facilities. Improved technology increases the rate of replacement
and, if it
affects service lives of the short-lived
and
lonq-lived facilities disproportionately,
will
alter the composition
of investment for both
replacement
and expansion.
Government

policies such as those dealing with pollution
abatement contain incentives for reallocating
investment,
as do provisions of the tax code.
The investment
tax credit, until 1978, excluded structures.
Although
the exclusion
may have been less binding in practice than
the code would suggest, the tax credit still
favored a shift in investment
toward shortlived facilities. Economic conditions,
as reflected in relative prices (or rates of return)
on capital, uncertainty,and
businessexpectations, also feed back into a firm's investment
decision, affecting both the level and composition of total investment.

Investment Composition

in the 1970s

Investment
decisions are not likely to
generate a smooth flow of short-lived
and
long-lived facilities into the capital stock.
Investment
is "lumpy,"
in that, for example,
a factory is added or replaced at one time
rather than adjusted gradually by the 100square-foot
piece. Thus, investment composition will vary, and, in a single firm or even
a sample of similar firms for a single year,
measured composition
can deviate from the
characteristic
combination
of facilities. For
a sample of firms over several years, however,
the lumpiness of investment should be largely
smoothed,
and a representative
estimate of
investment composition
can be derived.
Estimates
of investment
composition
(machinery/structures
in constant dollars) are
presented in table 1. The estimates are calculated from a sample of 19 Fourth District
firms that are producers
of machinery
and
equipment.
Restricting
the sample to firms
in capital-goods
industries holds constant, in
a simple way, the capital intensity of manufacturing operations.
Because firm size (the
level of investment) does not obviously influence composition,
no size restrictions
were
imposed. Large manufacturers
do not necessari Iy employ different capital processes, only
more capital than small manufacturers.
For
some firms in the sample, investment
in
structures appeared especially lumpy, which
contributed
very low compositional
ratios
in "factory
building years" and very high
ratios in other years. Separate estimates (the

August 11, 1980
adjusted sample) were computed
excluding
these firms.
The outstanding
feature of the estimates
in table 1 is the clear shift in investment composition toward short-lived capital facilities
during the 1970s. Measured by the geometric
mean of the individual ratios, composition
in
1976-79 included 5.6 units (1972 dollars) of
machinery for each unit of structures.
This
was more than 40 percent higher than the
compositional
ratio of 3.9 that was characteristic of the 1970-73 period. Relative dispersion among ratios was about the same in the
two periods, suggesting a true shift in the
distribution
of ratios rather than simply
greater dissimilarities
among firms in the
post-recession period.
A similar but somewhat less pronounced
shift is indicated by the estimates from the
adjusted sample. When firms that experience
the highest variability of investment composition are excluded, the compositional
ratio in
1976-79 is nearly 30 percent higher than in
1970-73. Relative dispersion among the ratios
in the adjusted sample is lower in 1976-79.
The recession years of 1974-75 do not
appear out of line with a shift in investment
composition
during the decade, despite economic conditions that might be expected to
disrupt investment patterns. The greater relative dispersion during the recession may reflect the effect of more varied business
expectations
at this time, but the variability
seems confined to the firms excluded from
the adjusted sample.
What caused the shift in the composition
of investment?
Factors such as technology
and government
regulation
no doubt were
important, especially if the origins of changes
are traced back to the 1960s. Computer technology is an obvious technological
force in
the period that is likely to increase machinery
relative to structures.
Pollution regulations
appeared in the late 1960s, probably
with
with similar effect. While these developments
would exert continuing
influence on investment composition,
and help explain why a
firm's machinery/structures
ratio would be
higher in the 1970s than earlier, it is less clear
that they would account for sharp changes
during the 1970s. Economic conditions in the

1970s, however, were volatile. The economy
experienced the worst business recession since
the 1930s. Recurring
energy price shocks
after 1973 added to economic uncertainty.
Inflation was a persistent problem throughout the 1970s, and in the latter part of the
decade inflationary
pressures intensified.
Inflation stems from many sources and
is not represented
by proportional
increases
in all individual prices. Some prices rise faster
than others, and relative prices as well as the
price level change in an inflationary environment. Even if the overall rate of inflation
were correctly anticipated
by firms, changes
in relative prices could influence investment
and its composition
through adjustments
in
a firm's demand for factors of production.
Indeed, the composition
of investment could
change regardless of what happens to the
level of investment.
Suppose a firm's demand for capital (and
the level of investment)
is unaffected by relative price changes associated with inflation.
A direct incentive to reallocate investment
could still arise if the relative price of machinery versus structures
changes. Judging
only from price indexes (implicit deflators)
of capital goods, the price of structures rose
faster than the price of machinery
in the
1970s. This was true, however, throughout
the decade, and the relative price change in
favor of machinery
was greater in 1970-73
than in 1976-79. To the firm, of course, the
important
consideration
in an investment
decision is the increase in costs from acquisitions of capital facilities. This is measured by
the rental price of capital, which is a broader
concept than a price such as the implicit deflator. The rental price includes, in addition
to the price index, the effects of taxes, depreciation, interest rates, and the firm's financial
structure.
Although
rental prices may have
moved similarly to price indexes in the 1970s,
this is uncertain. The impairment of depreciation allowances by inflation may have been
greater for structures than machinery, especially in 1976-79.
Of course, relative price effects alter the
demand for capital compared with other factors of production
and change the level of
investment.
On balance, relative factor price

movements
in the late-1970s
probably depressed the level of investment
(retarded
investment growth) and induced firms to hire
more labor.J In addition, energy price shocks
after 1973 were incentives for firms to conserve on the use of energy. Even if the relative price of machinery versus structures were
unchanged,
a firm substituting
labor for capital and conserving on energy would probably
shift its investment composition
toward the
machinery
component.
Incoming
workers
would require, in the absence of expanding
investment, a larger proportion of investment
going to machinery. Rapidly increasing energy prices could well have contributed
to the
observed compositional
changes by shortening service lives of less-energy-efficient
machinery in the existing capital stock and thus
increasing the rate of machinery replacement
relative to structures.
Additional
problems arise if inflationary
pressures are not uniform over time. If variability in the rate of inflation results in a
smaller
likelihood
that
inflation
will be
correctly
anticipated,
a firm's uncertainty
about future prices rises. This uncertainty
may be transitory,
in the sense that any
errors in anticipating
the rate of inflation
will, over time, net out to zero. If so, no
long-run influence on the level or composition
of real investment would be associated with
misinterpreting
inflationary
pressures.
A
short-run effect could exist, and, if the variability of inflation increases with the rate of
inflation, as some studies show, expectational
errors may be reinforcing during periods of
high inflation rates.f

3. This is consistent with the macro evidence on investment and employment
growth cited above.
Once again, depreciation
is an important
channel through which the rental price of (total)
capital is increased during inflation, as are corporate tax rates and the firm's financial structure. For a technical analysis of these effects on
capital,
see M. Feldstein,
J. Green, and E.
Sheshinski,
"Intlation
and Taxes in a Growing
Economy
with Debt and Equity
Finance,"
Journal of Political Economy (April 1978, part
2), pp. S53-70.
4. See Edward Foster, "The Variability
of Inflation,"
Review of Economics and Statistics
(August 1978), pp, 345-50.

The rate of inflation in 1976-79 was, on
simple measures,
more variable as well as
higher than in the early 1970s. Greater uncertainty
about
prices in the post-recession
period
followed
increases
in uncertainty
already generated
by the recession, which
were causing
firms to re-examine
many
aspects of the way they conducted
business.
As uncertainty
increases, binding commitments
become
a less desirable
business
policy.
For a firm's investment
decision,
structures
represent a more binding commitment than machinery. The shift in the composition of investment in the 1970s thus may
have been in part a reaction, though perhaps
temporary,
to the uncertain economic conditions of the time.

Conclusions
A pronounced shift in investment toward
short-lived
machinery
occurred
during the
1970s. Although the sample of firms examined was small and restricted to three industry
groupings (and therefore
not representative
of the economy as a whole), this evidence is
consistent
with broader
tendencies
noted
elsewhere.f
The shift was not associated with
growing dissimilarities among firms, nor does
it seem to have been the result of sudden
changes in technology or other long-run determinants of investment composition.
It could
well have been part of the inflationary
environment and uncertain economic conditions
of the decade. Apart from the level of investment, the shift in composition
suggests that
capital processes were formed that contributed to relatively slow expansion of potential
output. It is possible, for example, that much
of the investment effort in the late-1970s was
directed at improving energy efficiency rather
than capacity or labor productivity.
Longerterm implications are difficult to identify and
depend to a high degree on whether the economic conditions of the 1970s continue into
the 1980s.

5. See Burton G. Malkiel, "Productivity-the
Problem Behind the Headlines,"
Harvard Business
Review (May/June 1979), pp. 82-3.

ECONOMIC
COMMENTARY
In this issue:

Shifts In the Composition of
Fixed Investment In the 1970s

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

August 11, 1980
adjusted sample) were computed
excluding
these firms.
The outstanding
feature of the estimates
in table 1 is the clear shift in investment composition toward short-lived capital facilities
during the 1970s. Measured by the geometric
mean of the individual ratios, composition
in
1976-79 included 5.6 units (1972 dollars) of
machinery for each unit of structures.
This
was more than 40 percent higher than the
compositional
ratio of 3.9 that was characteristic of the 1970-73 period. Relative dispersion among ratios was about the same in the
two periods, suggesting a true shift in the
distribution
of ratios rather than simply
greater dissimilarities
among firms in the
post-recession period.
A similar but somewhat less pronounced
shift is indicated by the estimates from the
adjusted sample. When firms that experience
the highest variability of investment composition are excluded, the compositional
ratio in
1976-79 is nearly 30 percent higher than in
1970-73. Relative dispersion among the ratios
in the adjusted sample is lower in 1976-79.
The recession years of 1974-75 do not
appear out of line with a shift in investment
composition
during the decade, despite economic conditions that might be expected to
disrupt investment patterns. The greater relative dispersion during the recession may reflect the effect of more varied business
expectations
at this time, but the variability
seems confined to the firms excluded from
the adjusted sample.
What caused the shift in the composition
of investment?
Factors such as technology
and government
regulation
no doubt were
important, especially if the origins of changes
are traced back to the 1960s. Computer technology is an obvious technological
force in
the period that is likely to increase machinery
relative to structures.
Pollution regulations
appeared in the late 1960s, probably
with
with similar effect. While these developments
would exert continuing
influence on investment composition,
and help explain why a
firm's machinery/structures
ratio would be
higher in the 1970s than earlier, it is less clear
that they would account for sharp changes
during the 1970s. Economic conditions in the

1970s, however, were volatile. The economy
experienced the worst business recession since
the 1930s. Recurring
energy price shocks
after 1973 added to economic uncertainty.
Inflation was a persistent problem throughout the 1970s, and in the latter part of the
decade inflationary
pressures intensified.
Inflation stems from many sources and
is not represented
by proportional
increases
in all individual prices. Some prices rise faster
than others, and relative prices as well as the
price level change in an inflationary environment. Even if the overall rate of inflation
were correctly anticipated
by firms, changes
in relative prices could influence investment
and its composition
through adjustments
in
a firm's demand for factors of production.
Indeed, the composition
of investment could
change regardless of what happens to the
level of investment.
Suppose a firm's demand for capital (and
the level of investment)
is unaffected by relative price changes associated with inflation.
A direct incentive to reallocate investment
could still arise if the relative price of machinery versus structures
changes. Judging
only from price indexes (implicit deflators)
of capital goods, the price of structures rose
faster than the price of machinery
in the
1970s. This was true, however, throughout
the decade, and the relative price change in
favor of machinery
was greater in 1970-73
than in 1976-79. To the firm, of course, the
important
consideration
in an investment
decision is the increase in costs from acquisitions of capital facilities. This is measured by
the rental price of capital, which is a broader
concept than a price such as the implicit deflator. The rental price includes, in addition
to the price index, the effects of taxes, depreciation, interest rates, and the firm's financial
structure.
Although
rental prices may have
moved similarly to price indexes in the 1970s,
this is uncertain. The impairment of depreciation allowances by inflation may have been
greater for structures than machinery, especially in 1976-79.
Of course, relative price effects alter the
demand for capital compared with other factors of production
and change the level of
investment.
On balance, relative factor price

movements
in the late-1970s
probably depressed the level of investment
(retarded
investment growth) and induced firms to hire
more labor.J In addition, energy price shocks
after 1973 were incentives for firms to conserve on the use of energy. Even if the relative price of machinery versus structures were
unchanged,
a firm substituting
labor for capital and conserving on energy would probably
shift its investment composition
toward the
machinery
component.
Incoming
workers
would require, in the absence of expanding
investment, a larger proportion of investment
going to machinery. Rapidly increasing energy prices could well have contributed
to the
observed compositional
changes by shortening service lives of less-energy-efficient
machinery in the existing capital stock and thus
increasing the rate of machinery replacement
relative to structures.
Additional
problems arise if inflationary
pressures are not uniform over time. If variability in the rate of inflation results in a
smaller
likelihood
that
inflation
will be
correctly
anticipated,
a firm's uncertainty
about future prices rises. This uncertainty
may be transitory,
in the sense that any
errors in anticipating
the rate of inflation
will, over time, net out to zero. If so, no
long-run influence on the level or composition
of real investment would be associated with
misinterpreting
inflationary
pressures.
A
short-run effect could exist, and, if the variability of inflation increases with the rate of
inflation, as some studies show, expectational
errors may be reinforcing during periods of
high inflation rates.f

3. This is consistent with the macro evidence on investment and employment
growth cited above.
Once again, depreciation
is an important
channel through which the rental price of (total)
capital is increased during inflation, as are corporate tax rates and the firm's financial structure. For a technical analysis of these effects on
capital,
see M. Feldstein,
J. Green, and E.
Sheshinski,
"Intlation
and Taxes in a Growing
Economy
with Debt and Equity
Finance,"
Journal of Political Economy (April 1978, part
2), pp. S53-70.
4. See Edward Foster, "The Variability
of Inflation,"
Review of Economics and Statistics
(August 1978), pp, 345-50.

The rate of inflation in 1976-79 was, on
simple measures,
more variable as well as
higher than in the early 1970s. Greater uncertainty
about
prices in the post-recession
period
followed
increases
in uncertainty
already generated
by the recession, which
were causing
firms to re-examine
many
aspects of the way they conducted
business.
As uncertainty
increases, binding commitments
become
a less desirable
business
policy.
For a firm's investment
decision,
structures
represent a more binding commitment than machinery. The shift in the composition of investment in the 1970s thus may
have been in part a reaction, though perhaps
temporary,
to the uncertain economic conditions of the time.

Conclusions
A pronounced shift in investment toward
short-lived
machinery
occurred
during the
1970s. Although the sample of firms examined was small and restricted to three industry
groupings (and therefore
not representative
of the economy as a whole), this evidence is
consistent
with broader
tendencies
noted
elsewhere.f
The shift was not associated with
growing dissimilarities among firms, nor does
it seem to have been the result of sudden
changes in technology or other long-run determinants of investment composition.
It could
well have been part of the inflationary
environment and uncertain economic conditions
of the decade. Apart from the level of investment, the shift in composition
suggests that
capital processes were formed that contributed to relatively slow expansion of potential
output. It is possible, for example, that much
of the investment effort in the late-1970s was
directed at improving energy efficiency rather
than capacity or labor productivity.
Longerterm implications are difficult to identify and
depend to a high degree on whether the economic conditions of the 1970s continue into
the 1980s.

5. See Burton G. Malkiel, "Productivity-the
Problem Behind the Headlines,"
Harvard Business
Review (May/June 1979), pp. 82-3.

ECONOMIC
COMMENTARY
In this issue:

Shifts In the Composition of
Fixed Investment In the 1970s

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385