Dundee Discussion Papers in Economics 169: Cyclical uncertainty and physical investment decisions

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.