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

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  • Chen, Yu-Fu
  • Funke, Michael

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://repo.sire.ac.uk/handle/10943/105
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Bibliographic Info

Paper provided by Scottish Institute for Research in Economics (SIRE) in its series SIRE Discussion Papers with number 2009-31.

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Date of creation: 2009
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Handle: RePEc:edn:sirdps:105

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

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Cited by:
  1. 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.
  2. Funke, Michael & Paetz, Michael, 2013. "Housing prices and the business cycle: An empirical application to Hong Kong," Journal of Housing Economics, Elsevier, vol. 22(1), pages 62-76.

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