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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.

Suggested Citation

  • Yu-Fu Chen & Michael Funke, 2009. "Booms, Recessions and Financial Turmoil: A Fresh Look at Investment Decisions under Cyclical Uncertainty," CESifo Working Paper Series 2759, CESifo.
    • Handle: RePEc:ces:ceswps:_2759
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    More about this item

    Keywords

    business cycles; real options; investment; Markov switching; Tobin's q; uncertainty;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles

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