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Volatility, Investment and Disappointment Aversion

  • Joshua Aizenman
  • Nancy Marion

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).

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5386.

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Date of creation: Dec 1995
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Publication status: published as (Published as "Volatility and Investment") Economica, Vol. 66 (1999): 157-179.
Handle: RePEc:nbr:nberwo:5386
Note: ITI
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  1. 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.
  2. Pindyck, Robert S. & Solimano, Andrés., 1993. "Economic instability and aggregate investment," Working papers 3552-93., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  3. 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.
  4. 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.
  5. Gilboa, Itzhak, 1987. "Expected utility with purely subjective non-additive probabilities," Journal of Mathematical Economics, Elsevier, vol. 16(1), pages 65-88, February.
  6. Segal, Uzi & Spivak, Avia, 1990. "First order versus second order risk aversion," Journal of Economic Theory, Elsevier, vol. 51(1), pages 111-125, June.
  7. Aizenman, Joshua & Marion, Nancy P, 1993. "Policy Uncertainty, Persistence and Growth," Review of International Economics, Wiley Blackwell, vol. 1(2), pages 145-63, June.
  8. Gul, Faruk, 1991. "A Theory of Disappointment Aversion," Econometrica, Econometric Society, vol. 59(3), pages 667-86, May.
  9. Pfeffermann, G.P. & Madarassy, A., 1992. "Trends in Private Investment in Developing Countries," Papers 16, World Bank - International Finance Corporation.
  10. Hartman, Richard, 1972. "The effects of price and cost uncertainty on investment," Journal of Economic Theory, Elsevier, vol. 5(2), pages 258-266, October.
  11. Abel, Andrew B, 1983. "Optimal Investment under Uncertainty," American Economic Review, American Economic Association, vol. 73(1), pages 228-33, March.
  12. David Schmeidler, 1989. "Subjective Probability and Expected Utility without Additivity," Levine's Working Paper Archive 7662, David K. Levine.
  13. Barro, Robert J, 1991. "Economic Growth in a Cross Section of Countries," The Quarterly Journal of Economics, MIT Press, vol. 106(2), pages 407-43, May.
  14. 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.
  15. Pfeffermann, G.P. & Madarassy, A., 1992. "Trend in Private Investment in Developing Countries," Papers 14, World Bank - International Finance Corporation.
  16. Avinash K. Dixit & Robert S. Pindyck, 1994. "Investment under Uncertainty," Economics Books, Princeton University Press, edition 1, volume 1, number 5474, April.
  17. 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.
  18. 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.
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