IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Login to save this paper or follow this series

Uncertainty, Financial Frictions, and Investment Dynamics

  • Jae Sim

    (Federal Reserve Board)

  • Egon Zakrajsek

    (Federal Reserve Board)

  • Simon Gilchrist

    (Boston University)

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.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: https://www.economicdynamics.org/meetpapers/2010/paper_1285.pdf
Download Restriction: no

Paper provided by Society for Economic Dynamics in its series 2010 Meeting Papers with number 1285.

as
in new window

Length:
Date of creation: 2010
Date of revision:
Handle: RePEc:red:sed010:1285
Contact details of provider: Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
Fax: 1-314-444-8731
Web page: http://www.EconomicDynamics.org/society.htm
Email:


More information through EDIRC

References listed on IDEAS
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.:

as in new window
  1. Anonymous, 2006. "Washington Scene," Choices, Agricultural and Applied Economics Association, vol. 21(2).
  2. Bolton, Patrick & Scharfstein, David S, 1996. "Optimal Debt Structure and the Number of Creditors," Journal of Political Economy, University of Chicago Press, vol. 104(1), pages 1-25, February.
  3. Urban Jermann & Vincenzo Quadrini, 2006. "Financial innovations and macroeconomic volatility," Proceedings, Federal Reserve Bank of San Francisco, issue Nov.
  4. Ruediger Bachmann & Christian Bayer, 2009. "Firm-Specific Productivity Risk over the Business Cycle: Facts and Aggregate Implications," 2009 Meeting Papers 869, Society for Economic Dynamics.
  5. Eberly, Janice & Rebelo, Sergio & Vincent, Nicolas, 2012. "What explains the lagged-investment effect?," Journal of Monetary Economics, Elsevier, vol. 59(4), pages 370-380.
  6. Russell W. Cooper & John C. Haltiwanger, 2000. "On the Nature of Capital Adjustment Costs," NBER Working Papers 7925, National Bureau of Economic Research, Inc.
  7. Aubhik Khan & Julia Thomas, 2007. "Idiosyncratic Shocks and the Role of Nonconvexities in Plant and Aggregate Investment Dynamics," NBER Working Papers 12845, National Bureau of Economic Research, Inc.
  8. John Moore & Nobuhiro Kiyotaki, . "Credit Cycles," Discussion Papers 1995-5, Edinburgh School of Economics, University of Edinburgh.
  9. John Y. Campbell, 2001. "Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk," Journal of Finance, American Finance Association, vol. 56(1), pages 1-43, 02.
  10. Nir Jaimovich & Sergio Rebelo, 2006. "Can News About the Future Drive the Business Cycle?," 2006 Meeting Papers 31, Society for Economic Dynamics.
  11. Anonymous, 2006. "Front Materials," Western Economics Forum, Western Agricultural Economics Association, vol. 5(02).
  12. Anonymous, 2006. "Editorial Information," Journal of Food Distribution Research, Food Distribution Research Society, vol. 37(01), March.
  13. A. Colin Cameron & Jonah B. Gelbach & Douglas L. Miller, 2011. "Robust Inference With Multiway Clustering," Journal of Business & Economic Statistics, Taylor & Francis Journals, vol. 29(2), pages 238-249, April.
  14. Zhu Wang, 2006. "Online banking comes of age," TEN, Federal Reserve Bank of Kansas City, issue Win, pages 22-25.
  15. Anonymous, 2006. "Cover Page and Contents," Journal of Agricultural and Resource Economics, Western Agricultural Economics Association, vol. 31(02), August.
  16. Simon Gilchrist & Charles P. Himmelberg, 1993. "Evidence on the role of cash flow for investment," Finance and Economics Discussion Series 93-7, Board of Governors of the Federal Reserve System (U.S.).
  17. Tauchen, George, 1986. "Finite state markov-chain approximations to univariate and vector autoregressions," Economics Letters, Elsevier, vol. 20(2), pages 177-181.
  18. anonymous, 2006. "Call for Nominations," Management Science, INFORMS, vol. 52(3), pages 472-472, March.
  19. M Arellano & O Bover, 1990. "Another Look at the Instrumental Variable Estimation of Error-Components Models," CEP Discussion Papers dp0007, Centre for Economic Performance, LSE.
  20. Susanto Basu & Luigi Pascali & Fabio Schiantarelli & Luis Serven, 2009. "Productivity, Welfare and Reallocation: Theory and Firm Level Evidence," Boston College Working Papers in Economics 728, Boston College Department of Economics, revised 12 Jul 2010.
  21. Margaret M. McConnell & Gabriel Perez Quiros, 1998. "Output fluctuations in the United States: what has changed since the early 1980s?," Staff Reports 41, Federal Reserve Bank of New York.
  22. Marcelo L. Veracierto, 2002. "Plant-Level Irreversible Investment and Equilibrium Business Cycles," American Economic Review, American Economic Association, vol. 92(1), pages 181-197, March.
  23. Adina Popescu & Frank Rafael Smets, 2010. "Uncertainty, Risk-taking, and the Business Cycle in Germany," CESifo Economic Studies, CESifo, vol. 56(4), pages 596-626, December.
  24. Anonymous, 2006. "Front Materials," Choices, Agricultural and Applied Economics Association, vol. 21(4).
  25. Phillips, Peter C.B. & Sul, Donggyu, 2007. "Bias in dynamic panel estimation with fixed effects, incidental trends and cross section dependence," Journal of Econometrics, Elsevier, vol. 137(1), pages 162-188, March.
  26. Christopher A. Hennessy & Toni M. Whited, 2007. "How Costly Is External Financing? Evidence from a Structural Estimation," Journal of Finance, American Finance Association, vol. 62(4), pages 1705-1745, 08.
  27. Anonymous, 2006. "Front Material," Journal of Agricultural and Resource Economics, Western Agricultural Economics Association, vol. 31(03), December.
  28. Anonymous, 2006. "Washington Scene," Choices, Agricultural and Applied Economics Association, vol. 21(4).
  29. Thomas Philippon, 2009. "The Bond Market's q," The Quarterly Journal of Economics, MIT Press, vol. 124(3), pages 1011-1056, August.
  30. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  31. Krusell, P & Smith Jr, A-A, 1995. "Income and Wealth Heterogeneity in the Macroeconomic," RCER Working Papers 399, University of Rochester - Center for Economic Research (RCER).
  32. Andrew B. Abel & Janice C. Eberly, 1993. "A Unified Model of Investment Under Uncertainty," NBER Working Papers 4296, National Bureau of Economic Research, Inc.
  33. Gustavo Manso, 2008. "Investment Reversibility and Agency Cost of Debt," Econometrica, Econometric Society, vol. 76(2), pages 437-442, 03.
  34. Anonymous, 2006. "Contents Page," Agricultural and Resource Economics Review, Northeastern Agricultural and Resource Economics Association, vol. 35(1), April.
  35. Anonymous, 2006. "Front Materials," Choices, Agricultural and Applied Economics Association, vol. 21(3).
  36. Morten O. Ravn & Harald Uhlig, 2002. "On adjusting the Hodrick-Prescott filter for the frequency of observations," The Review of Economics and Statistics, MIT Press, vol. 84(2), pages 371-375.
  37. anonymous, 2006. "Community profile: Arizona," Community Investments, Federal Reserve Bank of San Francisco, issue Oct, pages 9.
  38. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
  39. Anonymous, 2006. "Inside Front Cover," Agricultural and Resource Economics Review, Northeastern Agricultural and Resource Economics Association, vol. 35(1), April.
  40. Anonymous, 2006. "Contents Page," Agricultural and Resource Economics Review, Northeastern Agricultural and Resource Economics Association, vol. 35(2), October.
  41. Gertler, Mark & Lown, Cara S, 1999. "The Information in the High-Yield Bond Spread for the Business Cycle: Evidence and Some Implications," Oxford Review of Economic Policy, Oxford University Press, vol. 15(3), pages 132-50, Autumn.
  42. Anonymous, 2006. "Contents and Cover Page," Journal of Rural Cooperation, Hebrew University, Center for Agricultural Economic Research, vol. 34(2).
  43. R?diger Bachmann & Ricardo J. Caballero & Eduardo M. R. A. Engel, 2013. "Aggregate Implications of Lumpy Investment: New Evidence and a DSGE Model," American Economic Journal: Macroeconomics, American Economic Association, vol. 5(4), pages 29-67, October.
  44. Caballero, Ricardo J. & Pindyck, Robert S., 1992. "Uncertainty, investment, and industry evolution," Working papers 3460-92., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  45. Simon Gilchrist & Egon Zakrajsek, 2007. "Investment and the Cost of Capital: New Evidence from the Corporate Bond Market," NBER Working Papers 13174, National Bureau of Economic Research, Inc.
  46. Anonymous, 2006. "Contents Pages," Journal of Food Distribution Research, Food Distribution Research Society, vol. 37(01), March.
  47. Anonymous, 2006. "Cover and Contents Pages," Journal of Agricultural and Resource Economics, Western Agricultural Economics Association, vol. 31(01), April.
  48. Lawrence H. Summers, 1981. "Taxation and Corporate Investment: A q-Theory Approach," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 12(1), pages 67-140.
  49. Ambrogio Cesa-Bianchi & M. Hashem Pesaran & Alessandro Rebucci, 2014. "Uncertainty and Economic Activity: A Global Perspective," CESifo Working Paper Series 4736, CESifo Group Munich.
  50. Anonymous, 2006. "Front Materials," Western Economics Forum, Western Agricultural Economics Association, vol. 5(01).
  51. Anonymous, 2006. "Contents Pages," Journal of Food Distribution Research, Food Distribution Research Society, vol. 37(02), July.
  52. Hidvegi, Zoltan & Wang, Wenli & Whinston, Andrew B., 2006. "Buy-price English auction," Journal of Economic Theory, Elsevier, vol. 129(1), pages 31-56, July.
  53. Wang, Hung-Jen, 2006. "Stochastic frontier models," MPRA Paper 31079, University Library of Munich, Germany.
  54. John V. Leahy & Toni M. Whited, 1995. "The Effect of Uncertainty on Investment: Some Stylized Facts," NBER Working Papers 4986, National Bureau of Economic Research, Inc.
  55. Carhart, Mark M, 1997. " On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, vol. 52(1), pages 57-82, March.
  56. Anonymous, 2006. "Front Materials," Choices, Agricultural and Applied Economics Association, vol. 21(2).
  57. R?diger Bachmann & Steffen Elstner & Eric R. Sims, 2013. "Uncertainty and Economic Activity: Evidence from Business Survey Data," American Economic Journal: Macroeconomics, American Economic Association, vol. 5(2), pages 217-49, April.
  58. Anonymous, 2006. "Cover and Contents Page," Journal of Food Distribution Research, Food Distribution Research Society, vol. 37(03), November.
  59. Arellano, Manuel, 2003. "Panel Data Econometrics," OUP Catalogue, Oxford University Press, number 9780199245291, March.
  60. anonymous, 2006. "Georgia mirrors the nation," EconSouth, Federal Reserve Bank of Atlanta, issue Q 4.
  61. Jonah B. Gelbach & Doug Miller, 2009. "Robust Inference with Multi-way Clustering," Working Papers 99, University of California, Davis, Department of Economics.
  62. Long Chen & Pierre Collin-Dufresne & Robert S. Goldstein, 2009. "On the Relation Between the Credit Spread Puzzle and the Equity Premium Puzzle," Review of Financial Studies, Society for Financial Studies, vol. 22(9), pages 3367-3409, September.
  63. John Haltiwanger & Russell Cooper & Laura Power, 1999. "Machine Replacement and the Business Cycle: Lumps and Bumps," American Economic Review, American Economic Association, vol. 89(4), pages 921-946, September.
  64. Mark T. Leary & Roni Michaely, 2011. "Determinants of Dividend Smoothing: Empirical Evidence," Review of Financial Studies, Society for Financial Studies, vol. 24(10), pages 3197-3249.
  65. Shleifer, Andrei & Vishny, Robert W, 1992. " Liquidation Values and Debt Capacity: A Market Equilibrium Approach," Journal of Finance, American Finance Association, vol. 47(4), pages 1343-66, September.
  66. Anonymous, 2006. "Cover and Table of Contents," Journal of Agricultural and Applied Economics, Southern Agricultural Economics Association, vol. 38(01), April.
  67. Abel, Andrew B, 1983. "Optimal Investment under Uncertainty," American Economic Review, American Economic Association, vol. 73(1), pages 228-33, March.
  68. Anonymous, 2006. "Front Cover," Agricultural and Resource Economics Review, Northeastern Agricultural and Resource Economics Association, vol. 35(1), April.
  69. Anonymous, 2006. "Cover And Contents Pages," Journal of Agricultural and Applied Economics, Southern Agricultural Economics Association, vol. 38(02), August.
  70. Anonymous, 2006. "Front Cover," Agricultural and Resource Economics Review, Northeastern Agricultural and Resource Economics Association, vol. 35(2), October.
  71. Anonymous, 2006. "Inside Front Cover," Agricultural and Resource Economics Review, Northeastern Agricultural and Resource Economics Association, vol. 35(2), October.
  72. Andrea L. Eisfeldt, 2004. "Endogenous Liquidity in Asset Markets," Journal of Finance, American Finance Association, vol. 59(1), pages 1-30, 02.
  73. Anonymous, 2006. "Contents and Cover Page," Journal of Rural Cooperation, Hebrew University, Center for Agricultural Economic Research, vol. 34(1).
  74. Anonymous, 2006. "Contents Pages," Journal of Agricultural and Resource Economics, Western Agricultural Economics Association, vol. 31(03), December.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:red:sed010:1285. 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: (Christian Zimmermann)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.