Real Estate and the Economy: Aggregate Implications of Irreversible Investment

66 Pages Posted: 2 Apr 2007

See all articles by Robert Novy-Marx

Robert Novy-Marx

Simon Business School, University of Rochester; National Bureau of Economic Research (NBER)

Date Written: January 2007


While significant effort has been devoted to characterizing the role that irreversibility plays in individual agents' investment behavior, very little has been devoted to the aggregate economic implications of investment irreversibility. Yet irreversibility prevents the continual allocation of capital to its most productive use, with first-order economic consequences. Moreover, the asymmetric nature of the friction, which prevents disinvestment in bad times but allows investment in good times, means its impact varies over the business cycle. In order to study the aggregate effects of irreversibility, this paper introduces a general equilibrium model with two consumption goods and irreversible investment. After characterizing the optimal investment strategy of competitive heterogeneous developers, we show that this behavior endogenously generates a business cycle: periods of more intensive real estate development are associated with greater consumption growth, even when fundamental shocks are stationary. We also consider an array of business cycle-dependent macroeconomic implications, including the impact of irreversibility on the term structures of interest rates and interest rate volatility, consumption risk premia, forward prices and forward price volatilities, and the expected returns to real assets. Finally, we consider the role that irreversibility plays in both the time-series and cross-section of investment, generating "lumpy" investment at the firm level and heterogeneity across firms. There is less heterogeneity, in equilibrium, than is socially optimal. Competitive pressures drive developers to build too soon, and consequently on too small a scale, to efficiently utilize resources diverted to the housing sector.

Keywords: Investment, Irreversibility, Real Estate, Tobin's Q, Real Options, General Equilibrium, Multiple Goods, Interest Rates, Asset Pricing

JEL Classification: E2, D5, G12, C0, R14

Suggested Citation

Novy-Marx, Robert, Real Estate and the Economy: Aggregate Implications of Irreversible Investment (January 2007). 9th Annual Texas Finance Festival Paper, Available at SSRN: or

Robert Novy-Marx (Contact Author)

Simon Business School, University of Rochester ( email )

Rochester, NY 14627
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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