NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Uncertainty and Investment Dynamics

Nick Bloom, John Van Reenen, Stephen Bond

NBER Working Paper No. 12383
Issued in July 2006
NBER Program(s):   EFG   PR

This paper shows that, with (partial) irreversibility, higher uncertainty reduces the impact effect of demand shocks on investment. Uncertainty increases real option values making firms more cautious when investing or disinvesting. This is confirmed both numerically for a model with a rich mix of adjustment costs, time-varying uncertainty, and aggregation over investment decisions and time, and also empirically for a panel of manufacturing firms. These cautionary effects of uncertainty are large – going from the lower quartile to the upper quartile of the uncertainty distribution typically halves the first year investment response to demand shocks. This implies the responsiveness of firms to any given policy stimulus may be much lower in periods of high uncertainty, such as after major shocks like OPEC I and 9/11.

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This paper was revised on September 7, 2006

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Document Object Identifier (DOI): 10.3386/w12383

Published: Nick Bloom & Stephen Bond & John Van Reenen, 2007. "Uncertainty and Investment Dynamics," Review of Economic Studies, Blackwell Publishing, vol. 74(2), pages 391-415, 04.

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