Pitfalls in Investment Euler Equations

This paper investigates three pitfalls concerning the test of the Euler equation facing quadratic adjustment costs and perfect capital markets on a large balanced panel data of 4025 French firms. First, the quadratic parameterization of adjustment costs is too restrictive, and power series approximations of adjustment costs are tested. Second, we isolate firms whose optimal Euler condition is not altered even in the presence of fixed adjustment costs. Third, we identify instruments which contribute to model failure via standard GMM tests. These methods point out that financial instruments contribute to reject strongly the standard model, which shows that it is misspecified.