Learning About Investment Risk: The Effects of Structural Uncertainty on Dynamic Investment and Consumption

Abstract

This paper examines the effects of incomplete information on dynamic investment and consumption in a general equilibrium model where shocks to capital are unobservable and there is structural or parameter uncertainty regarding the volatility of these shocks; i.e., the investment risk. In this model higher investment reduces the estimation error on the unobservable state variables, and thereby also reduces the estimation error on the unknown parameter. Investment policy therefore affects the speed of learning and is itself subsequently affected as estimation errors fall over time. We quantify the interaction of learning with investment by numerically computing equilibrium investment and consumption in a version of the model calibrated by aggregate US data. We find that imperfect observability (of productivity shocks) by itself does not significantly affect equilibrium investment and consumption. The introduction of structural or parameter uncertainty has significant effects on equilibrium investment and consumption, however. Moreover, investment and consumption levels in the presence of structural uncertainty are more quantitatively consistent with the data when compared to versions of the model that assume either complete information or incomplete information without structural uncertainty. The presence of structural uncertainty also appears to make consumption growth more volatile compared to the benchmark cases. Finally, and consistent with the theoretical analysis, the marginal propensity to invest is not monotone increasing with time even though the estimation errors are being reduced due to learning.

Keywords: Incomplete information, Structural uncertainty, Investment, Learning

JEL Classification: D2, D8, E2