Abstract
The traditional neoclassical model has played down the role of uncertainty in explaining investment and growth. This attitude stems from two observations — first, the direction of the impact of uncertainty on investment is ambiguous. Second, the magnitude of this effect is of a second-order importance — proportional to the variance of shocks. In neoclassical models concavity/convexity arguments ultimately determine the impact of uncertainty on investment. As Abel (1983) showed, in a competitive environment volatility increases investment at a rate proportional to the variance of shocks, whereas Caballero (1991) showed that market power weakens (and may even reverse) the impact of volatility on investment. Allowing for non-reversibility of investment does not resolve the ambiguity of the predicted effects of volatility on investment, as has been illustrated by Pindyck and Solimano (1993) and Dixit and Pindyck (1994). A logical consequence of these considerations is that uncertainty, driven by policy or nature, has been played down as an explanatory factor by the neoclassical investment and growth models. Instead, the focus has been on the first moment (the mean) and not the second moment (the volatility) of policies and shocks.
This study is part of the NBER’s research programme in International Trade and Investment. Any opinions expressed are mine and not those of the NBER, as indeed are any errors.
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Aizenman, J. (1998). Political Uncertainty, the Formation of New Activities and Growth. In: Borner, S., Paldam, M. (eds) The Political Dimension of Economic Growth. International Economic Association Series. Palgrave Macmillan, London. https://doi.org/10.1007/978-1-349-26284-7_8
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