The Finance Uncertainty Multiplier
Charles A. Dice Working Paper No. 2017-30
81 Pages Posted: 29 Dec 2017 Last revised: 11 Jan 2019
Date Written: January 10, 2019
We show how real and financial frictions amplify the impact of uncertainty shocks. We build a model with real frictions, and find adding financial frictions roughly doubles the impact of uncertainty shocks. Higher uncertainty alongside financial frictions induces the standard real-options effects on investment and hiring, but also leads firms to hoard cash, further reducing investment and hiring. We then test the model using a panel of US firms and a novel instrumentation strategy for uncertainty exploiting differential firm exposure to exchange rate and price volatility. Using common proxies for financial constraints, we show that ex-ante financially constrained firms cut investment and other real inputs more intensively than unconstrained firms following an uncertainty shock. These results highlight why in periods with greater financial frictions uncertainty can be particularly damaging.
Keywords: Uncertainty, Financial frictions, Investment, Employment, Cash holding, Equity payouts
JEL Classification: D22, E23, E44, G32
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