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CEP discussion paper
Uncertainty and Investment Dynamics
Nicholas Bloom, Stephen Bond and John Van Reenen
August 2006
Paper No' CEPDP0739:
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JEL Classification: D92; E22; D8; C23

Tags: investment; uncertainty; real options; panel data

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.

'Uncertainty and Company Investment Dynamics: Empirical Evidence for UK firms' Nick Bloom Steve Bond and John Van Reenen, Review of Economic Studies (2007) 74, 391-415