Booms, Recessions and Financial Turmoil: A Fresh Look at Investment Decisions under Cyclical Uncertainty

34 Pages Posted: 23 Aug 2009

See all articles by Yu-Fu Chen

Yu-Fu Chen

University of Dundee - Department of Economic Studies

Michael Funke

University of Hamburg - Department of Economics; Tallinn University of Technology (TUT)

Date Written: August 2009

Abstract

The paper studies the interaction between cyclical uncertainty and investment in a stochastic real option framework where demand shifts stochastically between three different states, each with different rates of drift and volatility. In our setting the shifts are governed by a three-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 and financial turmoil are important catalysts for waiting. In other words, our model shows that macroeconomic risk acts as an important deterrent to investments.

Keywords: business cycles, real options, investment, Markov switching, Tobin’s q, uncertainty

JEL Classification: D81, D92, E32

Suggested Citation

Chen, Yu-Fu and Funke, Michael, Booms, Recessions and Financial Turmoil: A Fresh Look at Investment Decisions under Cyclical Uncertainty (August 2009). CESifo Working Paper Series No. 2759, Available at SSRN: https://ssrn.com/abstract=1458870 or http://dx.doi.org/10.2139/ssrn.1458870

Yu-Fu Chen

University of Dundee - Department of Economic Studies ( email )

Dundee DD1 4HN, Scotland
United Kingdom
+44 1382 344 383 (Phone)
+44 1382 344 691 (Fax)

Michael Funke (Contact Author)

University of Hamburg - Department of Economics ( email )

Von-Melle-Park 5
room 2128 C rise
Hamburg, 20146
Germany

Tallinn University of Technology (TUT) ( email )

Ehitajate tee 5
Tallinn, 12618
Estonia

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