Uncertainty, Financial Frictions, and Investment Dynamics

The canonical framework used to price risky debt implies that the payoff structure of levered equity resembles the payoff of a call option, while the bondholders face a payoff structure that is equivalent to that of an investor writing a put option. As a result, an increase in the payoff uncertainty benefits equity holders at the expense of bondholders, a feature of the debt contract with two potentially important implications for real economic activity: First, to the extent that firms face significant frictions in financial markets, an increase in the default-risk premium implies a higher cost of capital and hence a decrease in investment. Second, a reduction in the supply of credit stemming from an increase in uncertainty hampers the efficient reallocation of capital and causes an endogenous decline in the total factor productivity (TFP) that amplifies the economic downturn. This paper analyzes---both empirically and theoretically---how fluctuations in uncertainty interact with financial market imperfections in determining economic outcomes. Using both aggregate time-series and firm-level data, we find strong evidence supporting the notion that financial frictions play a major role in shaping the uncertainty-investment nexus. We then develop a tractable general equilibrium model in which individual firms face time-varying uncertainty and imperfect capital markets when issuing risky bonds and equity to finance investment projects. We calibrate the uncertainty process using micro-level estimates of shocks to the firms' profits and show that the combination of uncertainty shocks and financial frictions can generate fluctuations in economic activity that are observationally equivalent to the TFP-driven business cycles.