The Impact of Short‐ and Long‐run Exchange Rate Uncertainty on Investment: A Panel Study of Industrial Countries*

Abstract

We examine the relationship between aggregate investment and exchange rate uncertainty in the G7, using panel estimation and decomposition of volatility derived from the components generalized autoregressive conditionally heteroscedastic (GARCH) model. Our dynamic panel approach takes account of potential cross-sectional heterogeneity, which can lead to bias in estimation. We find that for a poolable subsample of European countries, it is the transitory and not the permanent component of volatility which adversely affects investment. To the extent that short-run uncertainty in the CGARCH model characterizes higher frequency shocks generated by volatile short-term capital flows, these are most deleterious for investment.

Investment and the exchange rate: Short run and long run aggregate and sector-level estimates

“…Given that the dependent variable is a first difference and the sample is a pooled cross-section, the estimates explain a reasonable proportion of the variation in the difference of the log of investment. Further, the adjustment coefficient, λ-1, is negative as expected, the bounds test of Pesaran, Shin and Smith (2001) does not reject the existence of a long run relationship, and the speed of adjustment is either somewhat faster or similar to estimates found in other studies (Byrne and Davis, 2005, for example). 34 Test statistics provided in Tables 1 and 2 indicate that a Reset 33 With samples of the length employed here, consideration of more than two lags is not generally feasible (Pesaran, Smith and Akiyama, 1998;Pesaran, Shin and Smith, 1999).…”

“…The only impact of this change on the results is that this fiscal variable now becomes negative and significant in the Mining and quarrying sector. 41 Theoretical studies suggest that exchange rate uncertainty may affect investment, although the direction of this effect is uncertain, and empirical studies of the impact of exchange rate volatility on investment have yielded a variety of results (see, for example, Goldberg, 1993;Darby, Hughes Hallett, Ireland and Piscatelli, 1999;Hughes Hallett, Peersman, Piscitelli, 2004;Byrne and Davis, 2005;Campa and Goldberg, 1995;Bell and Campa, 1997;Serven, 2003;Atella, Atzeni and Belvisi, 2003). When an exchange rate volatility measure is added to the investment equation, it is insignificant in every sector except for Electricity, gas and water supply, where it has a negative long run impact.…”

“…A number of studies concentrate on the impact of changes in exchange rate variability on investment. Examples include Darby, Hughes Hallett, Ireland and Piscitelli (1999), Hughes Hallett, Peersman and Piscitelli (2004) and Byrne and Davis (2005). 5 An open economy exception is Goldberg (1993).…”

“…Among the few other open economy studies of investment that use cross-country panel data are Hughes Hallett, Peersman and Piscitelli (2004) and Byrne and Davis (2005). 7 Previous (non-investment related) studies that pool sector level data across countries include Peersman and Smets (2005) and Dedola and Lippi (2005).…”

Uncertainty and Private Investment Decision in Malaysia

“…We use GARCH/ARCH statistical models to capture the dynamics of volatility. The merits of using the ARCH/GARCH model are highlighted by Byrne and Davis (2005b) as they argue that ARCH/GARCH offer more of the theoretical characteristic of uncertainty than an unconditional measure. The ARCH/GARCH assumes that uncertainty changes people's perception and consequently, their responses to uncertainty (Note 6).…”