Investment is the firm’s version of the consumption problem, and we exploit the parallel throughout. It is close enough that the Hall-Jorgenson user cost of capital reads directly off an intertemporal first-order condition (the same Euler equation, with the marginal product of capital where the interest factor stood). The trouble with that frictionless benchmark is what it leaves out. It pins down the desired capital stock but says nothing about the rate at which a firm approaches it, so whenever user cost falls below the marginal product of capital the implied investment rate is unbounded.
Abel and Hayashi cure the indeterminacy by making adjustment costly. The shadow value of installed capital, , then becomes the state variable governing investment. The chapter closes with imperfect capital markets, which break the separation between a firm’s investment decision and its financial position, and so explain why cash flow helps predict investment even after controlling for .