Beyond Random Assignment: Credible Inference and Extrapolation in Dynamic Economies

We derive analytical relationships between shock responses and theory-implied causal effects (comparative statics) in dynamic settings with linear profits and linearquadratic stock accumulation costs. For permanent profitability shocks, responses can have incorrect signs, undershoot, or overshoot de...

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Bibliographic Details
Published in:The Journal of finance (New York) 2020-04, Vol.75 (2), p.825-866
Main Authors: HENNESSY, CHRISTOPHER A., STREBULAEV, ILYA A.
Format: Article
Language:English
Subjects:
Accumulation
Bias
Extrapolation
Profitability
Profits
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Summary:We derive analytical relationships between shock responses and theory-implied causal effects (comparative statics) in dynamic settings with linear profits and linearquadratic stock accumulation costs. For permanent profitability shocks, responses can have incorrect signs, undershoot, or overshoot depending on the size and sign of realized changes. For profitability shocks that are i.i.d., uniformly distributed, binary, or unanticipated and temporary, there is attenuation bias, which exceeds 50% under plausible parameterizations. We derive a novel sufficient condition for profitability shock responses to equal causal effects: martingale profitability. We establish a battery of sufficient conditions for correct sign estimation, including stochastic monotonicity. Simple extrapolation/error correction formulas are presented.
ISSN:0022-1082
1540-6261
DOI:10.1111/jofi.12862