Volatility, Investment and Disappointment Aversion
This study uncovers a statistically significant negative correlation between volatility and private investment over the 1970-93 period in a set of almost fifty developing countries and provides a possible interpretation of this result by using the disappointment- aversion expected utility framework first described by Gul (1991). We consider a number of different volatility measures related to domestic policies or to external factors. As the various volatility measures tend to be positively correlated, we do not claim to identify a unique measure as the dominant source of volatility. Instead, we demonstrate that for a number of different measures, volatility reduces private investment in developing countries. We then show that the disappointment-aversion framework provides a useful way of illustrating the adverse first-order effects of volatility. When agents are disappointment-averse, they put more weight on 'bad' outcomes and less weight on 'good' outcomes than in the standard case. The asymmetric weighting of outcomes introduces additional concavity into the utility function and causes volatility to have significant, negative effects on economic performance. The large, negative effects of increased volatility continue to hold even if the coefficient of relative risk aversion approaches zero (that is, even if the marginal utility of income is constant so that agents are risk neutral in the conventional sense).
|Date of creation:||Dec 1995|
|Date of revision:|
|Publication status:||published as (Published as "Volatility and Investment") Economica, Vol. 66 (1999): 157-179.|
|Contact details of provider:|| Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.|
Web page: http://www.nber.org
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Gul, Faruk, 1991. "A Theory of Disappointment Aversion," Econometrica, Econometric Society, vol. 59(3), pages 667-86, May.
- Avinash K. Dixit & Robert S. Pindyck, 1994. "Investment under Uncertainty," Economics Books, Princeton University Press, edition 1, volume 1, number 5474.
- Levine, Ross & Renelt, David, 1991.
"A sensitivity analysis of cross-country growth regressions,"
Policy Research Working Paper Series
609, The World Bank.
- Levine, Ross & Renelt, David, 1992. "A Sensitivity Analysis of Cross-Country Growth Regressions," American Economic Review, American Economic Association, vol. 82(4), pages 942-63, September.
- Itzhak Gilboa, 1987.
"Expected Utility with Purely Subjective Non-Additive Probabilities,"
- Gilboa, Itzhak, 1987. "Expected utility with purely subjective non-additive probabilities," Journal of Mathematical Economics, Elsevier, vol. 16(1), pages 65-88, February.
- Aizenman, Joshua, 1997.
"Investment in new activities and the welfare cost of uncertainty,"
Journal of Development Economics,
Elsevier, vol. 52(2), pages 259-277, April.
- Joshua Aizenman, 1995. "Investment in New Activities and the Welfare Cost of Uncertainty," NBER Working Papers 5041, National Bureau of Economic Research, Inc.
- Pindyck, Robert S. & Solimano, Andres, 1993.
"Economic instability and aggregate investment,"
Policy Research Working Paper Series
1148, The World Bank.
- Robert S. Pindyck & Andres Solimano, 1993. "Economic Instability and Aggregate Investment," NBER Working Papers 4380, National Bureau of Economic Research, Inc.
- Pindyck, Robert S. & Solimano, Andrés., 1993. "Economic instability and aggregate investment," Working papers 3552-93., Massachusetts Institute of Technology (MIT), Sloan School of Management.
- 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.
- Robert J. Barro, 1989.
"Economic Growth in a Cross Section of Countries,"
NBER Working Papers
3120, National Bureau of Economic Research, Inc.
- Aizenman, Joshua & Marion, Nancy P, 1993.
"Policy Uncertainty, Persistence and Growth,"
Review of International Economics,
Wiley Blackwell, vol. 1(2), pages 145-63, June.
- Uzi Segal & Avia Spivak, 1988.
"First Order Versus Second Order Risk Aversion,"
UCLA Economics Working Papers
540, UCLA Department of Economics.
- Pfeffermann, G.P. & Madarassy, A., 1992. "Trend in Private Investment in Developing Countries," Papers 14, World Bank - International Finance Corporation.
- Abel, Andrew B, 1983. "Optimal Investment under Uncertainty," American Economic Review, American Economic Association, vol. 73(1), pages 228-33, March.
- Harless, David W & Camerer, Colin F, 1994. "The Predictive Utility of Generalized Expected Utility Theories," Econometrica, Econometric Society, vol. 62(6), pages 1251-89, November.
- David Schmeidler, 1989.
"Subjective Probability and Expected Utility without Additivity,"
Levine's Working Paper Archive
7662, David K. Levine.
- Schmeidler, David, 1989. "Subjective Probability and Expected Utility without Additivity," Econometrica, Econometric Society, vol. 57(3), pages 571-87, May.
- Dow, James & Werlang, Sergio Ribeiro da Costa, 1992. "Uncertainty Aversion, Risk Aversion, and the Optimal Choice of Portfolio," Econometrica, Econometric Society, vol. 60(1), pages 197-204, January.
- Garey Ramey & Valerie A. Ramey, 1994.
"Cross-Country Evidence on the Link Between Volatility and Growth,"
NBER Working Papers
4959, National Bureau of Economic Research, Inc.
- Ramey, Garey & Ramey, Valerie A, 1995. "Cross-Country Evidence on the Link between Volatility and Growth," American Economic Review, American Economic Association, vol. 85(5), pages 1138-51, December.
- Hartman, Richard, 1972. "The effects of price and cost uncertainty on investment," Journal of Economic Theory, Elsevier, vol. 5(2), pages 258-266, October.
- Pfeffermann, G.P. & Madarassy, A., 1992. "Trends in Private Investment in Developing Countries," Papers 16, World Bank - International Finance Corporation.
When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:5386. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()
If references are entirely missing, you can add them using this form.