The Finance Uncertainty Multiplier

Abstract

We show theoretically and empirically how real and …nancial frictions amplify the impact of uncertainty shocks on …rms'investment, employment, debt (term structure of debt growth), and cash holding. We start by building a model with real and …nancial frictions, alongside uncertainty shocks, and show how adding …nancial frictions to the model roughly doubles the negative impact of uncertainty shocks on investment and hiring. The reason is higher uncertainty induces the standard negative real-options e¤ects on the demand for capital and labor, but also leads …rms to hoard cash and cut debt to hedge against future shocks, further reducing investment and hiring. We then test the model using a panel of US …rms and a novel instrumentation strategy for uncertainty exploiting di¤erential …rm exposure to exchange rate and factor price volatility. We …nd that higher uncertainty reduces real investment and hiring, while also leading …rms to increase cash holdings by cutting debt, dividends and stockbuy backs, and these e¤ects are strongest in periods of higher …nancial frictions and for the most …nancially constrained …rms. This highlights why in periods with greater …nancial frictions -like during the global-…nancial-crisis -uncertainty can be particularly damaging.

Uncertainty across volatility regimes

“…This second finding is consistent with the theoretical literature on "endogenous uncertainty," which contends that uncertainty is rather a consequence, not a cause, of declining economic activity, as, for example, in Van Nieuwerburgh and Veldkamp (2006), Bachmann and Moscarini (2012), Fajgelbaum, Taschereau-Dumouchel, and Schaal (2017), Gourio (2014), Navarro (2014), and Plante, Richter, and Throckmorton (2018). The fact that the relationship between uncertainty and real activity may not be constant over time is consistent with theoretical models that show how the effects of heightened uncertainty can be amplified in extreme conditions such as high financial stress (e.g., Alfaro, Bloom, & Lin, 2018;Arellano, Bai, & Kehoe, 2018;Gilchrist, Sim, & Zakrajsek, 2014) or when monetary policy is constrained by the zero lower bound (Basu & Bundick, 2017).…”

“…Finally, the estimated IRFs also line up with several contributions in the literature that highlight how uncertainty shocks have had larger effects after the GFC. This can be due to large financial frictions, as in Alfaro et al (2018), Caggiano, Castelnuovo, Delrio, and Robinson (2017), and Gilchrist et al (2014), or to the presence of the zero lower bound, as in Caggiano, Castelnuovo, and Pellegrino (2017) and Basu and Bundick (2017). They also support theoretical and empirical research that highlights how uncertainty shocks might have time-varying effects that depend on different macroeconomic conditions, such as the level of financial frictions (Alessandri and Mumtaz, 2018;Alfaro et al, 2018;Gilchrist et al, 2014), the stance of the business cycle (Cacciatore & Ravenna, 2016;Caggiano et al, 2014), or the stance of monetary policy (Basu & Bundick, 2017;Caggiano, Castelnuovo, & Pellegrino, 2017).…”

Brexit and Uncertainty: Insights from the Decision Maker Panel

“…Source: Bloomberg, Consensus Economics, Dow Jones Factiva, GfK (research on behalf of the European Commission), Thomson Reuters Datastream, www.policyuncertainty.com and authors' calculations. 11 Guiso and Parigi, 1999;Alfaro, Bloom and Lin, 2018;Smietanka, Bloom and Mizen, 2018. very little increase in stock market volatility (also shown on Figure 2). Other indicators that combine a range of macro data were in between the two but do not imply that Brexit was a historically large uncertainty shock ( Figure 2 also shows a principal-component-based measure used by the Bank of England and described by Haddow et al (2013) and a measure of macro uncertainty that estimates the conditional variance of the unforecastable component common to a large number of macroeconomic variables, of the type suggested by Jurado, Ludvigson and Ng (2015) and estimated for the UK by Redl (2017)).…”

Small and Large Firms over the Business Cycle

“…Thomas (2013), Gopinath et al (2015), Chaney et al (2015) and Alfaro, Bloom and Lin (2016), when the collateral constraint parameter is set to 0. The pattern of firms unable to obtain external funds, and forced to save their way to an optimal size, is the same; they are also present in microfounded models of debt issuance, such as Cooley and Quadrini (2001), Hennessy and Whited (2007), and Gilchrist, Sim and Zakrajšek (2014).…”