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Abstract:
Recent studies on irreversible investment literature suggest that levels of interest rates and tax rates are relatively less important than various uncertainty measures as determinants of aggregate investment. We attempt to find empirical evidence that aggregate uncertainty and, in particular, variability of inflation as an index of instability matters in aggregate investment decisions. We first follow the methodology of Solimano and Pindyck and, using cross-sectional data for nine OECD countries, observe very low cross-section correlation of inflation volatility and marginal profitability of capital volatility. When we allow for time-varying uncertainty and model it as a GARCH process, we uncover that volatility of marginal profitability of capital indeed changes over time and that GARCH processes of marginal profitability and inflation are the same for eight out of nine OECD countries in the sample. This suggests that the threshold required rate of return and the uncertainty proxied by the volatility of inflation are correlated and that they are moving over time. We conclude by noting the inadequacy of cross-sectional analysis for the testing the implications of the model when uncertainty follows a stochastic
process.
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