Aggregate investment spending is an important source of fluctuations over the business cycle. A puzzling aspect of such fluctuations is that they sometimes occur in connection with relatively small shocks or policy impulses. Previous contributions on the “small-shocks, large-cycles” puzzle have focused on borrowers’ credit-market conditions and their ability to propagate an initial real or monetary shock to the rest of the economy (Bernanke, Gertler, and Gilchrist, 1996 and 1998; and Hubbard, 1998).
This paper considers an alternative mechanism that may explain the observed large cyclical movements of investment with respect to the business cycle, based on firms’ behavior under uncertainty. Important early contributions on the relationship between investment and uncertainty include those of Lucas and Prescott (1971), Hartman (1972), Nickell (1977a and 1977b), and Abel (1983). In the last decade, research has focused on a class of models in which real options influence investment behavior, because firms may have an incentive to wait for the arrival of new information, thus postponing the implementation of their investment plans (Bertola, 1988; Pindyck, 1988; Caballero, 1991; and Dixit and Pindyck, 1994; see also the survey by Carruth, Dickerson, and Henley, 2000).
Theoretical analyses have shown that the impact of uncertainty on the level of the capital stock in the long run is ambiguous in this class of models (Abel and Eberly, 1999; and Caballero, 1999). Perhaps for this reason, empirical studies have not reached any consensus on the sign or significance of this long-run relationship. However, more recent theoretical contributions have emphasized the effects of uncertainty on short-run investment dynamics (Abel and Eberly, 1999; and Bloom, 2000), and empirical studies have found evidence consistent with the predicted weaker response of investment to demand shocks at higher levels of uncertainty (Guiso and Parigi, 1999; and Bloom, Bond, and Van Reenen, 2003).
This paper extends this empirical research using data on Italian firms. Following Bloom, Bond, and Van Reenen (2003), we test for the nonlinear and heterogeneous investment dynamics predicted by models with partial irreversibility and uncertainty. An important difference is that we do not rely on a stock-returns measure of uncertainty. Like Guiso and Parigi (1999), we use a sample of firms that is representative of the Italian manufacturing sector, for which we can derive a measure of uncertainty from survey responses of the managers who are responsible for the firms’ investment decisions. Exploiting the panel nature of our data set, we investigate the short-run effects of uncertainty on investment dynamics, thus extending the cross-sectional analysis of Guiso and Parigi (1999).
We find evidence of heterogeneity across firms in investment dynamics and, in particular, of a weaker effect of demand shocks on investment for firms facing higher uncertainty. Interestingly, our findings also point to an additional source of nonlinearity originating from a convex response of investment to positive demand shocks.
The supermodularity of a production function F(K1, K2, …, KN) is defined such that ∂F(K1 K2, .. . , KN)/∂Ki is increasing in all Kj,j ≠ i. See Dixit (1997).
See the Appendix for a more detailed description of the data set. Table A.1 provides a detailed breakdown of the sample according to the type of ownership, location, industry, and size of firms surveyed.
Only 3.9 percent of the firms sampled in 1997 are listed.
Again, the Appendix provides more details on this data set.
One disadvantage of our measure is that the predictability of future investment may itself depend on the level of adjustment costs. An implicit assumption of our empirical specification, in common with most of the previous literature, is that all firms in the sample face similar levels of adjustment costs. Unpredictability of future investment will then reflect uncertainty in the firm’s environment, rather than unusually low costs of adjustment.
See Carruth, Dickerson, and Henley (2000) for a survey of the most common measures of uncertainty employed in the investment literature.
Guiso and Parigi (1999) also reported that there was no clear relationship between their firm-level measure of uncertainty and a set of observable firm characteristics. The only exception was whether firms were privately owned or state-owned. In our sample, the latter group is not present.
We thank an anonymous referee for this suggestion.