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Investment Decisions under Real Exchange Rate Uncertainty

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  • Bahar Erdal
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    Abstract

    This paper analyzes the depressing effects of real exchange rate uncertainty on investment spending by using option pricing techniques. Investment under uncertainty assumes that investments are irreversible and can be delayed to wait for new information about prices, exchange rates and other macroeconomic variables. Irreversible investment spending is like a financial call option. When the opportunity to undertake irreversible investment is exercised, it kills the option of investing and the possibility of waiting for new information. Therefore, investment decisions of firms are sensitive to uncertainties over economic environment. Assuming present real exchange rate volatility is a proxy for real exchange rate uncertainty, and investment spending is like a call option, this paper shows that real exchange rate volatility causes optimal real exchange rate level to undertake investment to be higher for export-oriented sectors and lower for import-oriented sectors. Thus, the zone of “inaction” increases, and real investment spending falls as volatility increases regardless of whether the sector is an export-oriented or import-oriented sector.

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    Bibliographic Info

    Article provided by Research and Monetary Policy Department, Central Bank of the Republic of Turkey in its journal Central Bank Review.

    Volume (Year): 1 (2001)
    Issue (Month): 1 ()
    Pages: 25-47

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    Handle: RePEc:tcb:cebare:v:1:y:2001:i:1:p:25-47

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    Keywords: Real Exchange Rate; Uncertainty; Investment;

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    1. Charles Engel & Craig S. Hakkio, 1993. "Exchange rate regimes and volatility," Economic Review, Federal Reserve Bank of Kansas City, Federal Reserve Bank of Kansas City, issue Q III, pages 43-58.
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