Interest Rates, Policy Uncertainty, and Investment
AIER Sound Money Project Working Paper No. 2017–13
39 Pages Posted: 20 Jun 2015 Last revised: 8 Jan 2018
Date Written: June 18, 2015
In this paper, I estimate a cointegrated VAR with three long run equilibrium conditions that are consistent with the New Keynesian model. The equilibrium conditions estimated in the VAR do not provide evidence of a negative relationship between the federal funds rate and investment, or output more generally. Economic policy uncertainty, however, does have a negative and statistically significant effect on investment in the estimated model. I argue that the results support an option theory view of investment rather than the standard New Keynesian model. Also, various specifications of the model demonstrate that the findings are robust to an alternative short term nominal interest rate, the use of real interest rates rather than nominal interest rates, different classifications of investment, different measures of economic uncertainty, and a different specification of the monetary policy process. In addition, I argue that the results have implications for the weak recovery in the aftermath of the Great Recession. In particular, the results suggest that the increase in economic policy uncertainty observed after 2007 can potentially explain the weak recovery whereas the results cast doubt on the significance of the zero lower bound on nominal interest rates.
Keywords: investment, policy uncertainty, interest rates
JEL Classification: E22
Suggested Citation: Suggested Citation