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Uncertainty and Investment Dynamics

  • Nick Bloom
  • Stephen Bond
  • John Van Reenen

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.

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File URL: http://hdl.handle.net/10.1111/j.1467-937X.2007.00426.x
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Article provided by Oxford University Press in its journal The Review of Economic Studies.

Volume (Year): 74 (2007)
Issue (Month): 2 ()
Pages: 391-415

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Handle: RePEc:oup:restud:v:74:y:2007:i:2:p:391-415
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  27. Hartman, Richard, 1972. "The effects of price and cost uncertainty on investment," Journal of Economic Theory, Elsevier, vol. 5(2), pages 258-266, October.
  28. Nicholas Bloom, 2000. "The dynamic effects of real options and irreversibility on investment and labour demand," IFS Working Papers W00/15, Institute for Fiscal Studies.
  29. Bloom, Nicholas & Bond, Stephen Roy & Van Reenen, John, 2003. "Uncertainty and Company Investment Dynamics: Empirical Evidence for UK Firms," CEPR Discussion Papers 4025, C.E.P.R. Discussion Papers.
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