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Investment in New Activities and the Welfare Cost of Uncertainty

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  • Joshua Aizenman

Abstract

Recent literature has highlighted the importance of new activities in development and growth. It was shown that trade distortions such as tariffs are associated with first-order costs stemming from the induced drop in the formation of new activities. This paper demonstrates that uncertainty may induce similar costs. This argument is illustrated in the context of Romer's model of a dependent economy, where foreign direct investment is needed to enable the importation of capital goods and intermediate products used in domestic production. The present paper shows that uncertainty acts as an implicit tax on new activities, whose incidence is (in a certain sense) worse than that of a tariff in Romer's framework. As with a tariff, uncertainty inhibits the formation of new activities. Unlike the tariff, however, uncertainty does not benefit the government with revenue. The welfare cost of uncertainty applies also for a closed economy. The paper shows that uncertainty-averse entrepreneurs discount using a 'hurdle rate' that exceeds the risk-free interest rate. The gap between the two rates increases with the uncertainty embodied in the investment, being determined by the vagueness of the information and by the range of possible outcomes. Hence, growth may be inhibited by business uncertainty, where the 'rules of the game' for new activities are vague.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5041.

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Date of creation: Feb 1995
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Publication status: published as Journal of Development Economics, Vol. 52 (April 1997): 259-277.
Handle: RePEc:nbr:nberwo:5041

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  1. Caballero, Ricardo J, 1991. "On the Sign of the Investment-Uncertainty Relationship," American Economic Review, American Economic Association, vol. 81(1), pages 279-88, March.
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Citations

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Cited by:
  1. Keefer, Philip, 2004. "A review of the political economy of governance : from property rights to voice," Policy Research Working Paper Series 3315, The World Bank.
  2. Gradstein, Mark, 2002. "Rules, stability, and growth," Journal of Development Economics, Elsevier, vol. 67(2), pages 471-484, April.
  3. Joshua Aizenman, 1995. "Optimal Buffer Stocks and Precautionary Savings with Disappointment Aversion," NBER Working Papers 5361, National Bureau of Economic Research, Inc.
  4. Brunetti, Aymo, 1998. "Policy volatility and economic growth: A comparative, empirical analysis," European Journal of Political Economy, Elsevier, vol. 14(1), pages 35-52, February.
  5. Joshua Aizenman & Nancy Marion, 1995. "Volatility, Investment and Disappointment Aversion," NBER Working Papers 5386, National Bureau of Economic Research, Inc.
  6. Aizenman, Joshua & Marion, Nancy, 1999. "Volatility and Investment: Interpreting Evidence from Developing Countries," Economica, London School of Economics and Political Science, vol. 66(262), pages 157-79, May.
  7. Aizenman, Joshua, 1998. "Buffer stocks and precautionary savings with loss aversion," Journal of International Money and Finance, Elsevier, vol. 17(6), pages 931-947, December.
  8. Muthukumara Mani & Per G. Fredriksson, 2001. "Trade Integration and Political Turbulence," IMF Working Papers 01/150, International Monetary Fund.
  9. Shin-ichi Fukuda, 2001. "A Model of Keynesian under Knightian Uncertainty," CIRJE F-Series CIRJE-F-115, CIRJE, Faculty of Economics, University of Tokyo.
  10. Straathof,Bas, 2002. "Micro-uncertainty and growth," Research Memorandum 003, Maastricht University, Maastricht Economic Research Institute on Innovation and Technology (MERIT).

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