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Uncertainty and Investment Dynamics

  • Nick Bloom
  • John Van Reenen
  • Stephen Bond

This paper shows that, with (partial) irreversibility, higher uncertainty reduces the impact effect of demand shocks on investment. 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 %u2013 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 lower in periods of high uncertainty, such as after major shocks like OPEC I and 9/11.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12383.

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Date of creation: Jul 2006
Date of revision:
Publication status: published as Nick Bloom & Stephen Bond & John Van Reenen, 2007. "Uncertainty and Investment Dynamics," Review of Economic Studies, Blackwell Publishing, vol. 74(2), pages 391-415, 04.
Handle: RePEc:nbr:nberwo:12383
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