Working Paper

Uncertainty, Financial Frictions, and Investment Dynamics

Abstract: Micro- and macro-level evidence indicates that fluctuations in idiosyncratic uncertainty have a large effect on investment; the impact of uncertainty on investment occurs primarily through changes in credit spreads; and innovations in credit spreads have a strong effect on investment, irrespective of the level of uncertainty. These findings raise a question regarding the economic significance of the traditional \"wait-and-see\" effect of uncertainty shocks and point to financial distortions as the main mechanism through which fluctuations in uncertainty affect macroeconomic outcomes. The relative importance of these two mechanisms is analyzed within a quantitative general equilibrium model, featuring heterogeneous firms that face time-varying idiosyncratic uncertainty, irreversibility, nonconvex capital adjustment costs, and financial frictions. The model successfully replicates the stylized facts concerning the macroeconomic implications of uncertainty and financial shocks. By influencing the effective supply of credit, both types of shocks exert a powerful effect on investment and generate countercyclical credit spreads and procyclical leverage, dynamics consistent with the data and counter to those implied by the technology-driven real business cycle models.

Keywords: Time-varying volatility; asset specificity; capital liquidity shocks; costly external finance; firm heterogeneity; general equilibrium;

JEL Classification: E22; E32; G31;

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Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2014-04-01

Number: 2014-69

Pages: 60 pages