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Uncertainty and Investment Dynamics

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  • Nick Bloom
  • Stephen Bond
  • John Van Reenen

Abstract

This paper shows that with (partial) irreversibility higher uncertainty reduces the responsiveness of investment to demand shocks. Uncertainty increases real option values making firms more cautious when investing or disinvesting. This is confirmed both numerically for a model with a rich mix of adjustment costs, time-varying uncertainty, and aggregation over investment decisions and time and also empirically for a panel of manufacturing firms. These “cautionary effects” of uncertainty are large—going from the lower quartile to the upper quartile of the uncertainty distribution typically halves the first year investment response to demand shocks. This implies the responsiveness of firms to any given policy stimulus may be much weaker in periods of high uncertainty, such as after the 1973 oil crisis and September 11, 2001. Copyright 2007, Wiley-Blackwell.

Suggested Citation

  • Nick Bloom & Stephen Bond & John Van Reenen, 2007. "Uncertainty and Investment Dynamics," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 74(2), pages 391-415.
    • Handle: RePEc:oup:restud:v:74:y:2007:i:2:p:391-415
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    File URL: http://hdl.handle.net/10.1111/j.1467-937X.2007.00426.x
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    JEL classification:

    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • C23 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Models with Panel Data; Spatio-temporal Models

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