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  • Uncertainty, Financial Frictions, and Irreversible Investment

    Uncertainty, Financial Frictions, and Irreversible Investment

    Simon Gilchrist1 Jae W. Sim2 Egon Zakraǰsek2

    1Boston University and NBER

    2Federal Reserve Board

    International Monetary Fund May 2013

    DISCLAIMER: The views expressed are solely the responsibility of the authors and should not

    be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System

    or of anyone else associated with the Federal Reserve System.

  • Uncertainty, Financial Frictions, and Irreversible Investment

    Introduction

    EMPIRICAL OBSERVATIONS

    Economic uncertainty is time-varying and countercyclical. Campbell et al. (2001); Storesletten et al. (2004); Eisfeldt& Rampini (2006);

    Bloom (2009); Bloom et al. (2011)

    Credit spreads on corporate bonds are countercyclical. Gertler & Lown (1999); Gilchrist, Yankov & Zakrajšek (2009)

    Credit spreads predict economic activity. Philippon (2009); Gilchrist & Zakrajšek (2012); Faust et al. (2012); Bleaney et al. (2012)

  • Uncertainty, Financial Frictions, and Irreversible Investment

    Introduction

    MOTIVATION

    Existing literature: ◮ Investment-uncertainty nexus motivated byirreversibility.

    Bernanke (1983); Abel & Eberly (1994,1996); Caballero & Bertola (1994);

    Caballero & Pindyck (1996); Bloom (2009); Bloom et al. (2011)

    We examine the interaction between uncertainty and investment in the context ofimperfect financial marketsandirreversibility.

    We also analyze macroeconomic implications of fluctuations in capital liquidity. Shleifer & Vishny (1992); Eisfeldt (2004); Manso (2008)

  • Uncertainty, Financial Frictions, and Irreversible Investment

    Introduction

    UNCERTAINTY, FINANCIAL FRICTIONS & I NVESTMENT

    Standard debt contract: ◮ Payoff from holding a risky bond is aconcavefunction of the

    (stochastic) project return.

    Mean-preserving spread in the distribution of shocks: ◮ Perfectfinancial markets:

    • expected defaults↑ ⇒ credit spreads↑ ⇒ no impact onI ◮ Imperfectfinancial markets:

    • expected defaults↑ ⇒ credit spreads↑ ⇒ cost of capital↑ ⇒ I ↓

  • Uncertainty, Financial Frictions, and Irreversible Investment

    Introduction

    OUR PAPER

    Provides new empirical evidence on the link between uncertainty, business investment, and credit spreads. Develops a quantitative GE model that replicates key empirical relationships in the data:

    ◮ Embeds a costly reversible investment framework in a GE model with frictions in both the debt and equity markets.

    ◮ Generalizes previous GE frameworks. Kiyotaki & Moore (1997); BGG (1999); Jermann & Quadrini (2009)

    ◮ Allows for heterogeneity across firms in the economy. Chugh (2010); Arellano, Bai & Kehoe (2010); Kahn & Thomas (2010); Midrigan

    & Xu (2010); Christiano et al. (2013)

  • Uncertainty, Financial Frictions, and Irreversible Investment

    Introduction

    KEY RESULTS

    The impact of uncertainty shocks on business investment occurs primarily through changes in credit spreads. Model implications in response to uncertainty shock:

    ◮ Financial frictions magnify the impact of uncertainty shocks relative to a model with irreversible investment only.

    ◮ Negativecomovement between credit spreads and investment. ◮ Positivecomovement between net worth and investment.

    Model also implies substantial economic fluctuations in response to capital liquidity shocks.

  • Uncertainty, Financial Frictions, and Irreversible Investment

    Empirics

    A NEW UNCERTAINTY PROXY

    There is no objective measure of uncertainty.

    Informational and/or contractual frictions can generate countercyclical dispersion of economic returns. Eisfeldt & Rampini (2006); Jurado et al. (2013)

    Use information from the stock market to infer fluctuations in uncertainty:

    ◮ Cross Section: 11,303 U.S. nonfinancial corporations ◮ Time Series: July 1, 1963 to September 30, 2012

    Use a standard asset pricing framework to purge our uncertainty proxy of forecastable variation.

  • Uncertainty, Financial Frictions, and Irreversible Investment

    Empirics

    THREE-STEP ESTIMATION PROCEDURE

    Standard (linear) factor model of asset returns:

    (Ritd − r f td) = αi + β

    ′ iftd + uitd

    ◮ Risk factors: market excess return, SMB, HML, MOM

    Idiosyncratic uncertainty:

    σit =

    1 Dt

    Dt ∑

    d=1

    (ûitd − ūit) 2; ūit =

    1 Dt

    Dt ∑

    d=1

    ûitd

    Dynamic volatility model:

    logσit = γi + δit + ρ logσi,t−1 + vt + ǫit

    ◮ Benchmark uncertainty estimate: v̂t, t = 1, . . . ,T.

  • Uncertainty, Financial Frictions, and Irreversible Investment

    Empirics

    UNCERTAINTY & CREDIT SPREADS

    0

    20

    40

    60

    80

    100

    120

    140

    1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011 0

    1

    2

    3

    4

    5

    6

    7 Percent Percentage points

    Uncertainty (left scale) Credit spread (right scale)

    Quarterly

    NOTE: Credit spread is the (nonfinancial) 10-year BBB-Treasury spread.

  • Uncertainty, Financial Frictions, and Irreversible Investment

    Empirics

    Macro-Level Evidence

    SVAR ANALYSIS

    8-variable VAR(4) system: ◮ it = log of real business fixed investment ◮ cDt = log of real PCE on durable goods ◮ cNt = log of real PCE on nondurable goods & services ◮ yt = log of real GDP ◮ pt = log of the GDP price deflator ◮ v̂t = economic uncertainty ◮ st = 10-year BBB-Treasury corporate bond spread ◮ mt = effective (nominal) federal funds rate

    Implications of two types of shocks: ◮ Uncertainty: orthogonalized innovations in̂vt ◮ Financial: orthogonalized innovations inst

    Identification Scheme I: (it, cDt , c N t , yt, pt, v̂t, st,mt)

    Identification Scheme II: (it, cDt , c N t , yt, pt, st, v̂t,mt)

  • Uncertainty, Financial Frictions, and Irreversible Investment

    Empirics

    Macro-Level Evidence

    IMPLICATIONS OF AN UNCERTAINTY SHOCK Identification scheme I

    0 2 4 6 8 10 12 -2.5

    -2.0

    -1.5

    -1.0

    -0.5

    0.0

    0.5

    1.0 Percent

    Business fixed investment

    0 2 4 6 8 10 12 -2.5

    -2.0

    -1.5

    -1.0

    -0.5

    0.0

    0.5

    1.0 Percent

    Business fixed investment

    Quarters after shock 0 2 4 6 8 10 12

    -2.0

    -1.5

    -1.0

    -0.5

    0.0

    0.5

    1.0

    1.5 Percent

    PCE - durables

    0 2 4 6 8 10 12 -2.0

    -1.5

    -1.0

    -0.5

    0.0

    0.5

    1.0

    1.5 Percent

    PCE - durables

    Quarters after shock 0 2 4 6 8 10 12

    -0.4

    -0.3

    -0.2

    -0.1

    0.0

    0.1

    0.2

    0.3 Percent

    PCE - nondurables & services

    0 2 4 6 8 10 12 -0.4

    -0.3

    -0.2

    -0.1

    0.0

    0.1

    0.2

    0.3 Percent

    PCE - nondurables & services

    Quarters after shock

    0 2 4 6 8 10 12 -0.8

    -0.6

    -0.4

    -0.2

    0.0

    0.2

    0.4 Percent

    GDP

    0 2 4 6 8 10 12 -0.8

    -0.6

    -0.4

    -0.2

    0.0

    0.2

    0.4 Percent

    GDP

    Quarters after shock 0 2 4 6 8 10 12

    -2

    0 2 4

    6 8 10 12

    Percentage points

    Uncertainty

    0 2 4 6 8 10 12

    -2

    0 2 4

    6 8 10 12

    Percentage points

    Uncertainty

    Quarters after shock 0 2 4 6 8 10 12

    -0.2

    -0.1

    0.0

    0.1

    0.2

    0.3

    0.4

    0.5 Percentage points

    Credit spread

    0 2 4 6 8 10 12 -0.2

    -0.1

    0.0

    0.1

    0.2

    0.3

    0.4

    0.5 Percentage points

    Credit spread

    Quarters after shock

    NOTE: The shaded bands represent the 95-percent confidence intervals.

  • Uncertainty, Financial Frictions, and Irreversible Investment

    Empirics

    Macro-Level Evidence

    IMPLICATIONS OF A FINANCIAL SHOCK Identification scheme I

    0 2 4 6 8 10 12 -2.5

    -2.0

    -1.5

    -1.0

    -0.5

    0.0

    0.5

    1.0 Percent

    Business fixed investment

    0 2 4 6 8 10 12 -2.5

    -2.0

    -1.5

    -1.0

    -0.5

    0.0

    0.5

    1.0 Percent

    Business fixed investment

    Quarters after shock 0 2 4 6 8 10 12

    -2.0

    -1.5

    -1.0

    -0.5

    0.0

    0.5

    1.0

    1.5 Percent

    PCE - durables

    0 2 4 6 8 10 12 -2.0

    -1.5

    -1.0

    -0.5

    0.0

    0.5

    1.0

    1.5 Percent

    PCE - durables

    Quarters after shock 0 2 4 6 8 10 12

    -0.4

    -0.3

    -0.2

    -0.1

    0.0

    0.1

    0.2

    0.3 Percent

    PCE - nondurables & s