Uncertainty, Financial Frictions, and Irreversible Investment

Using macroand micro-level data, we establish three stylized facts: (1) fluctuations in idiosyncratic uncertainty can have a large effect on aggregate investment; (2) the impact of uncertainty on investment occurs largely through changes in credit spreads; and (3) financial shocks—identified vis-à-vis orthogonal innovations to credit spreads—have a strong effect on investment, irrespective of the level of uncertainty. These findings cast doubt on the traditional “wait-and-see” transmission channel of uncertainty shocks and point to financial distortions as the main mechanism through which fluctuation in uncertainty affect macroeconomic outcomes. We explore this hypothesis within a general equilibrium model, featuring heterogeneous firms that face time-varying uncertainty, nonconvex capital adjustment costs, and financial market frictions. We show that our model successfully replicates the stylized facts concerning the macroeconomic implications of uncertainty and financial shocks. By influencing the effective supply of credit, both shocks exert a powerful effect on aggregate 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. JEL Classification: E22, E32, G31