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Booms, Recessions and Financial Turmoil: A Fresh Look at Investment Decisions under Cyclical Uncertainty

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  • Yu-Fu Chen
  • Michael Funke

Abstract

The paper studies the interaction between cyclical uncertainty and investment in a stochastic real option framework where demand shifts stochastically between three different states, each with different rates of drift and volatility. In our setting the shifts are governed by a three-state Markov switching model with constant transition probabilities. The magnitude of the link between cyclical uncertainty and investment is quantified using simulations of the model. The chief implication of the model is that recessions and financial turmoil are important catalysts for waiting. In other words, our model shows that macroeconomic risk acts as an important deterrent to investments.

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File URL: http://www.dundee.ac.uk/media/dundeewebsite/economicstudies/documents/discussion/DDPE_225.pdf
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Bibliographic Info

Paper provided by Economic Studies, University of Dundee in its series Dundee Discussion Papers in Economics with number 225.

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Length: 29 pages
Date of creation: Jun 2009
Date of revision:
Handle: RePEc:dun:dpaper:225

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Keywords: Business Cycles; Real Options; Investment; Markov Switching; Tobin’s q; Uncertainty;

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Cited by:
  1. Michael Funke & Michael Paetz, 2011. "Housing Prices and the Business Cycle: An Empirical Application to Hong Kong," Quantitative Macroeconomics Working Papers 21112b, Hamburg University, Department of Economics.
  2. Michael, Funke & Michael, Paetz, 2010. "What Can an Open-Economy DSGE Model Tell Us about Hong Kong’s Housing Market?," BOFIT Discussion Papers 19/2010, Bank of Finland, Institute for Economies in Transition.

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