Cyclical uncertainty and physical investment decisions

Yu-Fu Chen, Michael Funke

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    Abstract

    The paper studies the interaction between cyclical uncertainty and investment in a stochastic real option framework where demand shifts stochastically between two different states, each with different rates of drift and volatility. In our setting the shifts are governed by a two-state Markov switching model with constant transition probabilities. The magnitude of the link between cyclical uncertainty and investment is quantified using simulations of the model. The chief implication of the model is that recessions are important catalysts for waiting. In other words, our model shows that macroeconomic risk acts as a deterrent to present investments.
    Original languageEnglish
    PublisherUniversity of Dundee
    Publication statusPublished - 2004

    Publication series

    NameDundee Discussion Papers in Economics
    PublisherUniversity of Dundee
    No.169
    ISSN (Print)1473-236X

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    Keywords

    • Business cycles
    • Real options
    • Investment
    • Markov switching
    • Tobin’s q
    • Uncertainty

    Cite this

    Chen, Y-F., & Funke, M. (2004). Cyclical uncertainty and physical investment decisions. (Dundee Discussion Papers in Economics; No. 169). University of Dundee.