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INVESTMENT IRREVERSIBILITY IN GENERAL EQUILIBRIUM: Capital Accumulation, Interest Rates, and the Risk Premium

  • Miquel Faig

This paper provides a tractable general equilibrium model that can accommodate shocks and irreversibility constraints both at the firm and at the aggregate level. Under realistic conditions, irreversibility not only prevents capital destruction, but it also promotes capital creation. Moreover, irreversibility depresses risk-free rates, especially in booms, and magnifies risk premia, especially in downturns. In addition to the theoretical analysis, two numerical examples illustrate the quantitative effects of investment irreversibility in the face of either large rare depressions or mild frequent recessions.

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File URL: http://www.economics.utoronto.ca/public/workingPapers/UT-ECIPA-FAIG-97-01.ps
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Paper provided by University of Toronto, Department of Economics in its series Working Papers with number faig-97-01.

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Length: 37 pages
Date of creation: 14 May 1997
Date of revision:
Handle: RePEc:tor:tecipa:faig-97-01
Contact details of provider: Postal: 150 St. George Street, Toronto, Ontario
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  2. Beaudry, Paul & Guay, Alain, 1996. "What do interest rates reveal about the functioning of real business cycle models?," Journal of Economic Dynamics and Control, Elsevier, vol. 20(9-10), pages 1661-1682.
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  8. R. Glenn Hubbard, 1994. "Investment under Uncertainty: Keeping One's Options Open," Journal of Economic Literature, American Economic Association, vol. 32(4), pages 1816-1831, December.
  9. Philippe Weil, 1989. "The Equity Premium Puzzle and the Riskfree Rate Puzzle," NBER Working Papers 2829, National Bureau of Economic Research, Inc.
  10. Dixit, Avinash K, 1989. "Entry and Exit Decisions under Uncertainty," Journal of Political Economy, University of Chicago Press, vol. 97(3), pages 620-38, June.
  11. Marcelo Veracierto, 1998. "Plant level irreversible investment and equilibrium business cycles," Working Paper Series WP-98-1, Federal Reserve Bank of Chicago.
  12. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
  13. Andrew B. Abel & Janice C. Eberly, 1995. "Optimal Investment with Costly Reversibility," NBER Working Papers 5091, National Bureau of Economic Research, Inc.
  14. Weil, Philippe, 1990. "Nonexpected Utility in Macroeconomics," The Quarterly Journal of Economics, MIT Press, vol. 105(1), pages 29-42, February.
  15. Bertola, Giuseppe, 1990. "Flexibility, Investment and Growth," CEPR Discussion Papers 422, C.E.P.R. Discussion Papers.
  16. Kocherlakota, N., 1995. "The Equity Premium: It's Still a Puzzle," Working Papers 95-05, University of Iowa, Department of Economics.
  17. Dow, James Jr. & Olson, Lars J., 1992. "Irreversibility and the behavior of aggregate stochastic growth models," Journal of Economic Dynamics and Control, Elsevier, vol. 16(2), pages 207-223, April.
  18. Bertola, Guiseppe & Caballero, Ricardo J, 1994. "Irreversibility and Aggregate Investment," Review of Economic Studies, Wiley Blackwell, vol. 61(2), pages 223-46, April.
  19. Lawrence J. Christiano & Jonas D.M. Fisher, 1997. "Algorithms for solving dynamic models with occasionally binding constraints," Working Paper 9711, Federal Reserve Bank of Cleveland.
  20. Pindyck, Robert S., 1986. "Irreversible investment, capacity choice, and the value of the firm," Working papers 1802-86., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  21. Leahy, John V, 1993. "Investment in Competitive Equilibrium: The Optimality of Myopic Behavior," The Quarterly Journal of Economics, MIT Press, vol. 108(4), pages 1105-33, November.
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  23. Huffman, Gregory W. & Wynne, Mark A., 1999. "The role of intratemporal adjustment costs in a multisector economy," Journal of Monetary Economics, Elsevier, vol. 43(2), pages 317-350, April.
  24. Pindyck, Robert, 1989. "Irreversibility, uncertainty, and investment," Policy Research Working Paper Series 294, The World Bank.
  25. Stephen G. Cecchetti & Pok-sang Lam & Nelson C. Mark, 1988. "Mean Reversion in Equilibrium Asset Prices," NBER Working Papers 2762, National Bureau of Economic Research, Inc.
  26. Ferson, Wayne E & Harvey, Campbell R, 1991. "The Variation of Economic Risk Premiums," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 385-415, April.
  27. Coleman Ii, Wilbur John, 1997. "Behavior Of Interest Rates In A General Equilibrium Multisector Model With Irreversible Investment," Macroeconomic Dynamics, Cambridge University Press, vol. 1(01), pages 206-227, January.
  28. Andrew B. Abel & Janice C. Eberly, 1995. "The Effects of Irreversibility and Uncertainty on Capital Accumulation," NBER Working Papers 5363, National Bureau of Economic Research, Inc.
  29. Olson, Lars J., 1989. "Stochastic growth with irreversible investment," Journal of Economic Theory, Elsevier, vol. 47(1), pages 101-129, February.
  30. Thomas Tallarini, . "Risk-Sensitive Real Business Cycles," GSIA Working Papers 1997-35, Carnegie Mellon University, Tepper School of Business.
  31. Caplin, Andrew & Leahy, John V, 1993. "Sectoral Shocks, Learning, and Aggregate Fluctuations," Review of Economic Studies, Wiley Blackwell, vol. 60(4), pages 777-94, October.
  32. Fama, Eugene F & French, Kenneth R, 1988. "Permanent and Temporary Components of Stock Prices," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 246-73, April.
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