Uncertainty and Investment Dynamics
Stanford University - Department of Economics; London School of Economics - Centre for Economic Performance (CEP); National Bureau of Economic Research (NBER)
Stephen R. Bond
Nuffield College; Institute for Fiscal Studies (IFS)
John Van Reenen
London School of Economics - Centre for Economic Performance (CEP); Institute for Fiscal Studies (IFS); Centre for Economic Policy Research (CEPR)
NBER Working Paper No. w12383
This paper shows that, with (partial) irreversibility, higher uncertainty reduces the impact effect of demand shocks on investment. Uncertainty increases real option values making firms more cautious when investing or disinvesting. This is confirmed both numerically for a model with a rich mix of adjustment costs, time-varying uncertainty, and aggregation over investment decisions and time, and also empirically for a panel of manufacturing firms. These cautionary effects of uncertainty are large %u2013 going from the lower quartile to the upper quartile of the uncertainty distribution typically halves the first year investment response to demand shocks. This implies the responsiveness of firms to any given policy stimulus may be much lower in periods of high uncertainty, such as after major shocks like OPEC I and 9/11.
Number of Pages in PDF File: 44working papers series
Date posted: September 14, 2006
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