Economic Instability and Aggregate Investment

Abstract

Abstract:A recent literature suggests that because investment expenditures are irreversible and can be delayed, they may be highly sensitive to uncertainty. We briefly summarize the theory, stressing its empirical implications. We then use cross-section and time-series data for a set of developing and industrialized countries to explore the relevance of the theory for aggregate investment. We find that the volatility of the marginal profitability of capital -a summary measure of uncertainty -affects investment as the theory suggests, but the size of the effect is moderate, and is greatest for developing countries. We also find that this volatility has little correlation with indicia of political instability used in recent studies of growth, as well as several indicia of economic instability. Only inflation is highly correlated with this volatility, and is also a robust explanator of investment. JEL Classification Numbers: E22; D92, E61.Keywords: Investment, uncertainty, irreversibility, economic instability, inflation.*Prepared for the NBER Macroeconomics Conference, March 12, 1993. The research leading to this paper was supported by M.I.T.'s Center for Energy and Environmental Policy Research, by the National Science Foundation through Grant No. SES90-22823 to R. Pindyck, and by the World Bank. Our thanks to Raimundo Soto and Yunyong Thaicharoen for their outstanding research assistance, to Sebastian Edwards for providing his data on political risk variables, and to Fischer Black, Olivier Blanchard, Michael Bruno, Ricardo Caballero, Jose de Gregorio, Janice Eberly, Stanley Fischer, Robert Hall, and Alwyn Young for helpful comments and suggestions.

On the sensitivity of firms' investment to cash flow and uncertainty

“…Hurn and Wright (1994) find that the linkage between oil price variability and the decision to develop an oil field (more specifically the North Sea oil field) is not significant. Pindyck and Solimano (1993) use the variance in the marginal revenue product of capital as a proxy for uncertainty to study an implication of irreversible investment models to find the effects of uncertainty on the investment trigger. Edmiston (2004) investigates the role of tax uncertainty on investment and finds a significant negative effect between the two.…”

Investment and Uncertainty in the G7

“…Some authors such as Pindyck and Solimano (1993) Justifying our focus on GARCH, we argue that the distinction between GARCH and moving average based volatility is a potentially important one, since heightened average volatility alone may merely reflect a greater incidence of random and independent shocks, i.e.…”

“…Following the derivation in Pindyck and Solimano (1993), one may consider at what point it is worth paying a sunk cost I for a project whose present value is V, if V evolves according to geometric Brownian motion, where dz is the increment of a Wiener process.…”

Macroeconomic Instability and the Incentive to Innovate

“…1 Some of these, in particular, have focused on the effects of macro-volatility on private investment activity, with sometime conflicting results (Hartman, 1972;Abel, 1983;Dehn, 2000;Pindyck and Solimano, 1993;Bernanke, 1980;Federer, 1993;Serven, 2003, Aghion et al, 2010. A few recent others have looked, in particular, at the link between macro-instability and innovative private investment, in the form of R&D expenditure (Aghion and Saint-Paul, 1998;Goel and Ram, 1999;Saint-Paul, 2003;Rafferty, 2003a;Barlevy, 2005;Aghion et al, 2008;Rafferty and Funk, 2008;Bohva-Padilla et al, 2009).…”