Investment Under Uncertainty With a Zero Lower Bound on Interest Rates

26 Pages Posted: 21 Apr 2016 Last revised: 18 Sep 2019

See all articles by George Dotsis

George Dotsis

National Kapodistrian University of Athens - Faculty of Economics; Essex Finance Centre, Essex Business School, University of Essex

Date Written: September 3, 2019

Abstract

This paper examines irreversible investment decisions when the interest rate is stochastic and constrained by a zero lower bound using the shadow-rate model of Black (1995). In contrast to the commonly found negative relationship between investment and uncertainty, it is shown that the presence of a lower bound on interest rates induces an asymmetric effect of interest rate uncertainty on investment decision. When the interest rate is low an increase in interest rate volatility decreases the value of waiting and increases investment but when the interest rate is high an increase in interest rate volatility increases the value of waiting and decreases investment. When interest rates are stuck at the lower bound and the shadow rate is substantially below the bound, the decision to invest or wait no longer depends on interest rate uncertainty and is determined entirely by cash flow volatility.

Keywords: irreversible investment decisions, zero lower bound, shadow interest rate

JEL Classification: G11, G12, G31

Suggested Citation

Dotsis, George, Investment Under Uncertainty With a Zero Lower Bound on Interest Rates (September 3, 2019). Available at SSRN: https://ssrn.com/abstract=2766923 or http://dx.doi.org/10.2139/ssrn.2766923

George Dotsis (Contact Author)

National Kapodistrian University of Athens - Faculty of Economics ( email )

Greece

HOME PAGE: http://sites.google.com/site/gdotsis/

Essex Finance Centre, Essex Business School, University of Essex ( email )

Wivenhoe Park
Colchester, CO4 3SQ
United Kingdom

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