Uncertainty, Financial Frictions, and Investment Dynamics
AbstractMicro- 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.