The Review of Economic Studies, LTD.: Oxford University Press

The Review of Economic Studies, Ltd.
Uncertainty and Investment Dynamics

Author(s): Nick Bloom, Stephen Bond and John van Reenen
Source: The Review of Economic Studies, Vol. 74, No. 2 (Apr., 2007), pp. 391-415
Published by: Oxford University Press
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Review of Economic Studies (2007) 74, 391-415 0034-6527/07/00140391$02.00
@ 2007 The Review of Economic Studies Limited
and
Uncertainty Investment
Dynamics
NICK BLOOM
StanfordUniversity,Centrefor EconomicPerformance,and NBER
STEPHENBOND
Institutefor Fiscal Studiesand Universityof Oxford
and
JOHN VAN REENEN
LondonSchool of Economics,
Centrefor EconomicPerformance,and CEPR
First version receivedFebruary2001; final version accepted September2006 (Eds.)
This papershows that with (partial)irreversibilityhigher uncertaintyreduces the responsivenessof

investmentto demandshocks. Uncertaintyincreasesreal option values makingfirmsmorecautiouswhen
investing or disinvesting.This is confirmedboth numericallyfor a model with a rich mix of adjustment
costs, time-varyinguncertainty,and aggregationover investmentdecisions and time and also empirically
for a panel of manufacturingfirms. These "cautionaryeffects" of uncertaintyare large-going from the
lower quartileto the upperquartileof the uncertaintydistributiontypically halves the firstyear investment
responseto demandshocks. This implies the responsivenessof firmsto any given policy stimulusmay be
much weakerin periodsof high uncertainty,such as afterthe 1973 oil crisis and September11, 2001.
1. INTRODUCTION
Recent theoretical analyses of investment under uncertaintyhave highlighted the effects of
irreversibilityin generating"realoptions"(e.g. Dixit andPindyck, 1994). In these models, uncer-
taintyincreasesthe separationbetween the marginalproductof capitalwhichjustifies investment
and the marginalproductof capital which justifies disinvestment.This increases the range of
inaction where investmentis zero as the firm prefers to "wait and see" ratherthan undertak-
ing a costly action with uncertainconsequences. In short, investmentbehaviourbecomes more
cautious.
Firm-level data are attractivefor investigatingthis effect of uncertaintyon the degree of
cautionsince empiricalmeasuresof uncertaintycan be constructedbased on shareprice volatility
(e.g. Leahy and Whited, 1996). One importantdifficultyfor directtesting of real options models
of investmentunderuncertaintyusing firm data, however, is the extreme rarityof observations
with zero investmentin annual consolidated accounts. If we believed that these firms make a
single investmentdecision in each year,this lack of zeros would rejectthe canonicalreal options
model of a single investmentdecision with its region of inaction. However,given the extensive
evidence of discrete and lumpy adjustmentsin more disaggregatedplant-level data (e.g. Doms
and Dunne, 1998), this lack of zeros at the firm level is suggestive of aggregationover types of
capital,productionunits, and time.
391

392 REVIEWOF ECONOMICSTUDIES
Previousresearchhas shownthataggregationdoes not eliminatethe impactof lumpymicro-

investment decisions for more aggregatedinvestment dynamics.1 This raises the question of
whetherthe effects of uncertaintyand irreversibilityon short-runinvestmentdynamics can be
detectedin an econometricstudy of firm-levelinvestmentspending.To investigatethis issue we
develop a model of the firm's investmentdecisions that allows for two types of capital, a rich
specificationof adjustmentcosts, time-varyinguncertainty,alternativefunctionalforms for the
revenue function, and extensive aggregationover time and over productionunits. We solve this
theoreticalmodel numericallyand simulatefirm-levelpanel data.We use these simulateddatain
two ways. First,we analyseit directlyto confirmtwo propertiesof firm-levelinvestmentdynam-
ics in this framework.One propertyis the effect of higheruncertaintyon the degree of cautionin
investmentdecisions as noted above. We show that,with (partial)irreversibility,the impacteffect
on investmentof a given firm-leveldemandshock tends to be weaker for firms that are subject
to a higher level of uncertainty.We also show that the responseof investmentto demandshocks
tends to be convex, as largershocks induce firms to invest in more types of capital and at more
productionunits (the extensive margin).This in turn induces more adjustmentat the intensive
margin, with these aggregationeffects being reinforcedby supermodularityin the production
technology.
We also use our simulateddata to show that both these effects can be detected using a rel-
atively simple dynamiceconometricspecificationto approximatethe complex firm-levelinvest-
ment dynamicsimpliedby this framework.Ourstartingpoint is an errorcorrectionmodel (ECM)
of investmentthat has been widely used in firm-levelstudies. We add two types of terms. First,
an interactionbetween real sales growthandmeasureduncertaintytests for the more cautiousre-
sponse of investmentto demandshocks at higherlevels of uncertainty.Second, a non-linearsales
growth term tests for convexity in the response of investmentto demand shocks. Generalized
Method of Moments (GMM) estimationon the simulatedpanel dataindicatesthat we can reject
the null hypothesis of a common, linearresponseof investmentto demandshocks, providedthe
dynamic specificationused is sufficientlyrich for standardtests of overidentifyingrestrictions
not to indicate severe misspecificationof the econometricmodel.
We then apply the same econometricapproachto study the investmentbehaviourof a sam-
ple of 672 publicly tradedU.K. manufacturingcompanies over the period 1972-1991, selected
because of the requirementfor detailedreportingof investmentand disinvestmentactivity in the
U.K. over this period. We find evidence both of more cautious investmentbehaviourfor firms
subjectto greateruncertaintyand of a convex responseof investmentto real sales growth.While
theremay be otherexplanationsfor these patternsin companyinvestmentdynamics,we conclude
that the investmentbehaviourof large firms is consistent with a partialirreversibilitymodel in
which uncertaintydampensthe short-runadjustmentof investmentto demandshocks.
Finally, simple simulationsusing our estimatedeconometricmodel suggest that observed
fluctuationsin uncertaintycan play an economically importantrole in shaping firm-level in-
vestment decisions. For example, we find that a one standarddeviation increase in our mea-
sure of uncertainty,like that which occurredafter September 11, 2001 and the 1973 oil crisis,
can halve the impact effect of demandshocks on company investment.While we do not model
the behaviourof labour demand, the existence of similar labour hiring and firing costs would
imply that higher uncertaintywould also make employmentresponses to demand shocks more
1. See, for example, Bertola and Caballero(1994), Caballeroand Engel (1999), Abel and Eberly (2001), and
Doyle and Whited (2001). Thomas (2002) and Veracierto(2002) find that in general equilibriummodels the impact of
non-convex investmentcosts on the businesscycle may be small. These papersare necessarilybased on relativelysimple
models of firminvestment-including a constantlevel of uncertainty-to enablecomplex generalequilibriummodelling.
Our focus here is on much richer(partialequilibrium)micro-modelsthat include fluctuationsin the level of uncertainty.
These are appropriatefor estimationon firm-leveldata.
? 2007 The Review of Economic Studies Limited

BLOOMETAL. UNCERTAINTYAND INVESTMENTDYNAMICS 393
cautious.This suggests thatfirmswill generallybe less responsiveto monetaryand fiscal stimuli

in periods of high uncertainty,which is importantfor policy-makerstrying to respondto major
shocks duringperiods of high uncertainty.2Severalpapershave also reportedevidence of an in-
crease in firm-specificuncertaintyin the U.S. and otherOECD countriesin recentyears,3which
our analysis indicatescould have significanteffects on investmentdynamics.
The plan of the paperis as follows. Section 2 considerstwo implicationsof uncertaintyand
irreversibilityfor investmentbehaviour and confirms these numericallyusing simulated data.
Section 3 develops our econometricinvestmentequation and shows, using the simulated data,
that tests based on this model can detect these effects on investmentdynamics. Section 4 takes
this econometricmodel to real companyinvestmentdatato test for the presence of these effects,
while Section 5 examines their magnitude.Section 6 offers some concludingremarks.
2. SIMULATINGINVESTMENTDYNAMICSUNDER UNCERTAINTY
The typical model in the literatureconsiders investmentin a single partiallyirreversiblecapital
good, with a Cobb-Douglas revenue function and demand conditions that follow a Brownian
motion process with constantvariance.Investmentonly occurs when the firm'smarginalrevenue
productof capital (MRPC) hits an upperthreshold,given by the traditionaluser cost of capital
plus an option value for investment. Similarly, disinvestmentonly occurs when the marginal
revenueproducthits a lower threshold,given by the user cost for selling capital less an option
value for disinvestment.The firmchooses to wait and do nothingif its MRPClies between these
two thresholds.
As the MRPC evolves stochasticallyover time this approachpredictsthat the firm will un-
dertakesporadicburstsof investmentor disinvestment,consistentwith the typical evidence from
plant-level data (see, for example, Doms and Dunne, 1998; or Nilson and Schiantarelli,2003).
Abel and Eberly (1996) show by comparativestatistics that the option values are increasingin
the (time-invariant)level of uncertainty.This suggests that firms which face a higher level of
uncertaintyare less likely to respondto a given demandshock.
2.1. Aggregationandfirm-level investment

Annual investmentdata for publicly tradedU.K. and U.S. firms, however, do not display the
discrete switches from zero to non-zero investmentregimes indicatedby this basic model. In
particular,observationswith zero investmentspending are almost completely absent from their
company accounts.Table 1 reportsevidence from our sample of 672 U.K. manufacturingcom-
panies and a sample of U.K. manufacturingestablishmentsthat contain one or more plants at
the same location. There are two distinctpatternsof aggregationthat can be observed: first, ag-
gregationacross types of capital (structures,equipment,and vehicles), and second, aggregation
across plants within the establishmentor the firm. In both cases we observe a higher proportion
of observationswith zero investmentwhen we consider more disaggregateddata. There is also
likely to be a thirdtype of aggregation-temporal aggregation-as the frequencyof shocks and
investmentdecisions is likely to be much higherthanthat of the (annual)data.
In view of this, we explicitly consider a frameworkin which firms invest in multiple types
of capital goods, across multiple productionunits, and there is aggregationover time. These
2. See Bloom (2006) for the evidence of steep rises in uncertaintyaftermajormacro-shocks.
3. Campbell,Lettau,Burtonand Xu (2001) study U.S. firms in the period 1962-1997 and find an increasein the
firm-level (but not market-level)volatility of annualizeddaily stock returnsin the 1980's and 1990's comparedto the
1960's and 1970's. See also Comin andPhilippon(2006) for evidence of increasedsales growthvolatilityfor public U.S.
firms and Thesmarand Thoenig (2003) for similar evidence for public French firms. Davis, Haltiwanger,Jarminand
Miranda(2006), however,show thatthis trendreverseswhen looking at privatefirms.

TABLE 1
Episodes of zero investmentin differenttypesof data
Observationswith zero investment(%)
Buildings Equipment Vehicles Total
Firms 5-9 0.1 n.a. 0.1
Establishments 46.8 3-2 21.2 1.8
Single plants 53.0 4-3 23.6 2.4
Small single plants 57.6 5.6 24.4 3-2
Note: Firm-level data (6019 annual observations)from Extel and

Datastream.Establishment-leveldata (46,089 annual observations)
from U.K. Census of Production(see Redutodos Reis, 1999).
productionunits experience idiosyncraticunit-level productivityshocks as well as a common

firm-leveldemand shock. In this more general framework,but in a model with a constantlevel
of uncertaintyand partial irreversibilitiesonly, Eberly and Van Mieghem (1997) have shown
that the optimal investmentdecisions for each unit will follow a multi-dimensionalthreshold
policy. Extendingthis to allow for time-varyinguncertaintyand temporalaggregationprovides
two implications,which are the focus of our simulationand empiricalinvestigation.
The first implicationis that the response of companyinvestmentto demandshocks should
be lower at higher levels of uncertaintydue to the "cautionary"effect of uncertainty.For each
productionunit or type of capital,the optionto wait anddo nothingis more valuablefor firmsthat
face a higher level of demanduncertainty.Following a given positive demandshock investment
by such firms is expected to be lower, as both less units (or types of capital) will invest (the
extensive margin) and each unit (type) that does invest will invest less (the intensive margin),
with any supermodularityin the productiontechnology reinforcingthese effects.4 Similarly,the
impact of a given negative demand shock on firm-level disinvestmentis also expected to be
smallerfor firmsthatface a higherlevel of uncertainty.
Second, the investmentresponsewill be convex in responseto positive demandshocks and
concave in response to negative demandshocks. When the firm experiencesa positive demand
shock it may invest in a greaternumberof productionunits or types of capital (the extensive
margin) and it may invest more in each unit or type of capital (the intensive margin). Larger
demandshocks will affect both margins,and any supermodularityin the productiontechnology
would make these two effects reinforcing.Thus, the more types of capitalthe firm is induced to
invest in, the more it wantsto investin those types of capitalthatare alreadyadjusting,generating
a convex response.The samereasoningalso suggeststhatthe responseof firm-leveldisinvestment
to negativedemandshocks will be concave.
As these investmentmodels do not have closed-formsolutionswe cannotprove these prop-
erties analytically.In the next section we confirmthem using numericalsimulations.
2.2. Thesimulationmodel
We start by parameterizingone model from the general class of supermodularhomogeneous
models that we are considering.Firms are assumed to operate a large collection of individual
productionunits, with the numberchosen to ensure that full aggregationhas occurred.In the
4. Supermodularityis a generalconceptfor complementarity.A functionf : Rn - R is definedas supermodularif

Vx, x' Rn, f(x) + f(x) < f (min(x, x'))+ f (max(x, x')). If f is twice differentiablethis implies a2f(x1X2,,Xn) >0
V i = j. The Cobb-Douglas and constantelasticity of substitution(CES) productionfunctionsare both supermodular.

simulationthis is set at 250 units per firm, chosen by increasingthe numberof units until the
resultswere no longer sensitive to this number.5
Each unit faces an iso-elastic demandcurve for its output,which is producedusing labour
and two types of capital. Demand conditions evolve as a geometric random walk with time-
varying uncertaintyand have a unit-specificidiosyncraticcomponentand a common firm-level
component. Demand shocks, uncertaintyshocks, and optimizationoccur in monthly discrete
time. Labouris costless to adjustwhile both types of capitalare costly to adjust.
2.2.1. The production unit model. In the basic model each productionunithas a reduced-
form supermodularrevenuefunction R(X, K1, K2) given by
R(X, K1, K2) = Xy Ka Kf2, (2.1)

based on an underlyingCobb-Douglas productionfunctionwith two types of capitalafterlabour,
a flexible factorof production,has been optimizedout. Demandandproductivityconditionshave
been combinedinto one index, X, henceforthcalled demandconditions.For computationaltrac-
tability,we normalizethis demandconditionsparameterthroughthe substitution,p(a-fl)/ly =
X, so thatthe revenuefunctionis homogeneousof degree one in (P, K1, K2), where
R(X, K1, K2) = R(P, K1, K2) (2.2)

=
p 1-a-P Ka K2 . (2.3)
In the simulationwe set a = 0.4 and fl = 0-4, correspondingto a 25% mark-upand constantre-
turnsto scale in the physical productionfunction,with equal coefficientson each type of capital.
Demand conditions are a composite of a unit-level (PU) and a firm-level(pF) component,
p = pU x pF. The unit-level demand(or productivity)conditions evolve over time as an aug-
mentedgeometricrandomwalk with stochasticvolatility:
PU = pU (1 + u (at) + at VtU), VU
- N
(0, 1) (2.4)
at = at- -1+ P (a * - at -1) + a Wt, Wt , N(0, 1). (2.5)
Here p (at) is the mean drift in unit-level demand conditions, a2 is the variance of unit-level
demand conditions,a* is the long-runmean of at, p, is the rate of convergenceto this mean,
and a2 is the varianceof the shocks to this varianceprocess. The terms VTUand Wtare the i.i.d.
shocks to unit-leveldemandand varianceconditions,respectively.
The firm-leveldemandprocess is also an augmentedgeometricrandomwalk with stochastic
volatility,which for tractabilitywe assume has the same mean and variance:
PtF PF_ + () + aVtF), VF N(0, 1). (2.6)
Hence, the overall demandprocess log P has drift 2,u(at) and variance2a2. While this demand
structuremay seem complex, it is formulatedto ensurethatunits withinthe same firmhave linked
investmentbehaviourdue to the common firm-level demand shocks and level of uncertainty,
but also display some independentbehaviourdue to idiosyncraticshocks. The baseline value of
2,u(at) is set to 4% (averagereal sales growth),invariantto the level of uncertainty,althoughwe
also reportbelow some experimentsthat allow for more generaldrifts.
5. In the U.K. Census of Productionmicro-data,the averagesize of a manufacturingproductionunit is about20

employees. The mean size of firms in our sample is 4440 employees, suggesting a mean of around220 units per firm.
Tests on specificationswith differentdegrees of cross-sectionalaggregation(5, 10, and 50 units per firm) and temporal
aggregation(two, four, and six periodsper year) confirmthe robustnessof our resultsto these assumptions.

The two types of capitalarecostly to adjust.We startby modellingonly partialirreversibility

adjustmentcosts whereby the resale price of a unit of capital is less than the purchaseprice.
Capitaltype 1 K1 is assumed more costly to adjust (e.g. specialized equipment),while capital
type 2 K2 is less costly to adjust (e.g. vehicles). For the simulationwe set the resale loss for
capitalof type 1 to 50% and the resale loss for capitalof type 2 to 20%.6
These adjustmentcosts are definedby the firm'sadjustmentcost function, C(P, K1, K2, II,
12). We assume, for numericaltractability,thatnewly investedcapitalentersproductionimmedi-
ately, thatboth types of capitaldepreciateat an annualizedrate of 10%,and that the firmhas an
annualizeddiscountrate of 10%.
2.2.2. Solving the production unit model. The complexity of the model necessitates
numericalsimulation,but analyticalresults can be used to show that the problemhas a unique-
valued continuoussolution7and an (almost everywhere)uniquepolicy function.This means our
numericalresults will be convergentwith the uniqueanalyticalsolution.
In principle, we have a model with too many state variablesto be solved using numerical
methods given the currentcomputingpower. The unit's optimizationproblem, however,can be
simplifiedby noting thatthe revenuefunction,adjustmentcost function,depreciationschedules,
andexpectationsoperatorsareall jointly homogeneousof degreeone in (P, K1, K2). This allows
us to normalizeby one statevariable-capital type 1-simplifying the model anddramaticallyin-
creasingthe speed of the numericalsolutionroutine.This effectively gives us one state"forfree",
in thatwe estimateon two majorstatespaces (j and 2), butfor threeunderlyingstatevariables.
The optimizationproblem(before normalization)can be statedas
V(Pt, Kit, K2t, Ut) = max R(Pt, Kit + Ilt, K2t + I2t) - C(Pt, Kit, K2t, Ilt, 12t)
Ilt,12t
1
+ E[V(Pt+1, (Kit +11t)(1 -6), (K2t+12t)(1 -6), t+l)],
1+r
where r is the discount rate, 6 is the depreciationrate, E[.] is the expectationsoperator,Ijt is
investmentin type j (j = 1,2) capitalat time t, and Kjt is the stock of type j capital.Using the
homogeneityin (P, K1, K2) this can be rewrittenas
Kit V(Pt*, 1, Kt, at) = max Klt R(Pt*, 1 + I*t, Kt (1 + I2t)) - KltC(Pt*, 1, K*, I*I*t tK2t)
11t'I2t
1
+ K1t+lE[V(Pt', 1 K*t+,
I+r at+l)],
where starredvariablesare K =- K, P* = ,I = , and I = normalizationby
2. Upon
Kit this simplifies to
t) = max R(Pt*, 1 + I, Kt(1+

-
V(Pt*, 1, Kt, 2*t)) C(P*, 1 K *t K
It,I•*t
+ - E])
+ (1 I*t)(1 E[V(Pt*+1, 1, K t+1,
1+r t+l)],
6. Our choice of adjustmentcost parametersis based on the literaturewhere available,in particularCooper and
Haltiwanger(2006). The qualitativeresultsfrom our analysis of the simulateddataarenot sensitive to moderatechanges
in the adjustmentcost parametervalues, althoughas discussedin Section 3.2, they are sensitive to the type of adjustment
costs considered.
7. An applicationof Stokey and Lucas (1989) for the continuous,concave, and almost surely bounded normal-
ized returnsand cost function for models with partialirreversibilities(this section) and quadraticadjustmentcosts, and
Caballeroand Leahy (1996) for the extension to models with fixed costs in Section 3.2.2.

which is a function of only the state variables ( K, a). We let uncertainty,at, take five
,
equally spaced values from 0.1 to 0.5, with a symmetricmonthly transitionmatrix that is ap-
proximatelycalibratedagainst(the varianceand autocorrelationof) our stock-returnsmeasureof
uncertaintyfor U.K. listed firms,describedin Section 4.1. The simulationis run on a state space
of ' , a) of (100,100,5).8
2.2.3. Aggregation to firm-level data. Simulateddata are generatedby taking the nu-
merical solutions for the optimal investmentfunctions and feeding in demand and uncertainty
shocks at a monthlyfrequency.The simulationis runfor 60 monthsto generatean initial ergodic
distribution.Annual firm-levelinvestmentdata are then generatedby aggregatingacross the two
types of capital, the 250 units, and 12 months within each year. Capital stocks and the level of
the demandconditions are summed across all units at the end of each year, while uncertaintyis
measuredas the averageyearly value.
2.3. Investigatingthe theoreticalimplications
Using the model and solution method outlined above we generatesimulatedinvestmentand de-
manddatafor a panel of 50,000 firmsand25 years.We confirmthe two implicationsfor short-run
investmentdynamics highlighted in Section 2.1 by consideringthe relationshipbetween firm-
level annual investment rates and demand growth in this simulated data. As the drift in the
demandprocess is common to all firms, and the idiosyncraticshocks are averagedacross 250
productionunits, there is a simple correspondencebetween demand growth and the firm-level
demandshock in this simulation.
Figure 1 presents lowess-smoothed non-parametricplots9 of investment against demand
growthfor observationsaroundthe 10th,25th, 50th, 75th, and 90th percentilesof the distribution
of uncertainty(Ut).10 Investmentrates are measuredas annualinvestmentdivided by the capi-
tal stock at the beginning of the year, and annualdemandgrowthis measuredas the percentage
change comparingthe beginningandthe end of the year.The firstimplication-that the short-run
response of investmentto demandshocks will be lower at higheruncertainty-indicates that the
slope of these response functions is lower at higher levels of uncertainty.It is evident that these
non-parametricregression estimates do indeed become flatteras the level of uncertaintyrises,
consistent with the first implication of the theoreticalmodel. In quantitativeterms, comparing
investmentresponses with -10% and +25% demandgrowth, the gradientof the investmentre-
sponse to demandgrowthapproximatelydoubles when moving from the thirdquartileto the first
quartileof the distributionof uncertaintyand approximatelytriples when moving from the 90th
percentileto the 10th percentile.Hence, differencesin the level of uncertaintygeneratesubstan-
tial variationin the short-runresponse of investmentto demand shocks, and this is clearly seen
8. We also need the optimal control space of (I,*, 1*) of dimension (100,100), so that the full returnsfunction in
the Bellman equationhas dimensionality(100,100,100,100,5). The programmeand a manualexplainingthe underlying
techniquesare availableat http://www.stanford.edu/~nbloom/ or from nbloom@stanford.edu
9. Lowess smoothingestimates a linearregressionat each datapoint, using Cleveland's(1979) tricubeweighting
over a moving window of 5% of the data, to generatea non-parametricallysmoothed data series. Lowess is similar to
Kernelsmoothing,but uses informationon both the mean and the slope of the dataand so is more efficient in estimating
functions with continuousfirst derivatives,which our aggregateddata have asymptotically(in the numberof production
units).
10. As this varianceparameterhas a five-pointprocess in the underlyingmonthly model we obtain considerable
clustering of observationsaroundthese values, even in the average annual firm data. Although we use 1.25 million
generatedobservations,there are no observationsin the sample at the 10th and the 25th percentilesof uncertaintywith
annualdemandgrowthabove 27% and 64%, respectively,so the lines are not estimatedbeyond these points.

80
-50th Percentileof
a) uncertainty
25thPercentile of
60 - uncertainty
•
10thPercentileof
40- uncertainty
75thPercentile of
uncertainty
20 - 90th Percentile of
Suncertainty
0-
-25 0 25 50 75 100
Averageannualfirmdemandgrowth(%)
FIGURE1
Averageinvestmentresponseto demandshocks at differentlevels of uncertainty,simulateddata
in our simulatedfirm-leveldatadespite extensive aggregationacross the two types of capital,the

250 productionunits, and the 12 monthlydecision periods.
The second implication-that the short-runresponseof investmentto demandshocks is non-
linear-indicates that these response functions are convex for positive investmentand concave
for negative investment.Focusing first on positive investment,it is evident that all five curves
are indeed convex, with a proportionallylargerresponse to largerpositive shocks. Looking at
negative investmentthe picture is unclear because even for large negative demand growth of
-25%, most firmsare still undertakingpositive gross investment.This reflectsthe combinationof
longer run dynamicswith pent-upinvestmentdemand,4% demanddrift, and 10%depreciation,
which even in the presence of relatively low degrees of irreversibilitygeneratesvery few firm-
level disinvestmentobservations(2%in our simulateddatasampleand 3%in the real U.K. data).
Thus, we cannotidentify the concavityin the disinvestmentresponsesin eitherthe simulationor
actualU.K. data, and thereforewe concentrateon the convex responsefor positive investmentin
the remainderof the paper.
3. EVALUATINGOUR EMPIRICALSPECIFICATION
The next step is to investigatethe empiricalimportanceof these propertiesof short-runinvest-
mentdynamicsin actualfirm-leveldata,which requiresan appropriateeconometricspecification.
If we observedthe trueunderlyingdemandshocks and demandvariancethis would be relatively
straightforwardas we could, for example,use the same non-parametricapproachused in the pre-
vious section to analyse short-runinvestmentresponsesto exogenous demandshocks. However,
in real firm-leveldata-setswe only observeproxies for demandgrowthsuch as firm sales growth
and proxies for uncertaintysuch as share price volatility. Among other issues, this requiresus
to deal with the problem that outcomes like sales and share prices arejointly determinedwith
the firm'sinvestmentdecisions. To do this we considerGMM estimatesof dynamiceconometric
investmentequations.
Ourstartingpoint is a reduced-formECM thatprovidesa flexible distinctionbetween short-
run influences on investmentrates and longer term influences on capital stocks. This has been
@ 2007 The Review of Economic StudiesLimited

widely used in recentempiricalstudiesof companyinvestmentbehaviour.11Bloom (2000) shows

that the actual capital stock series chosen by a firm underpartialirreversibilityhas a long-run
growthrateequal to thatof the hypotheticalcapitalstock series thatthe same firmwould choose
under costless reversibility,essentially because the gap between these two series is bounded.
This implies that the logarithmsof the two series should be cointegratedand thus provides one
motivationfor consideringan ECM of capitalstock adjustment.12
This cointegrationresultindicatesthat
logKit = logKit + eit, (3.1)

where Kit is the actualcapital stock for firmi in period t, Ki*is the capitalstock this firm would
have chosen in the absence of adjustmentcosts, andeit is a stationaryerrorterm.We specify this
hypotheticalfrictionlesslevel of the capitalstock as
logKi*t =logYit + A? + Bt, (3.2)

where Yitis the (real) sales of firmi in periodt, and A* and Br*are unobservedfirm-specificand
time-specificeffects reflectingpossible variationacross firmsin the componentsof and response
to the user cost of capital (Chetty,2007). This formulationis consistent, for example, with the
frictionlessdemandfor capitalfor a firmwith constantreturnsto scale CES productionfunction
and iso-elastic demand, and implies that the logs of the actual capital stock and real sales are
cointegrated,provided the user cost of capital is stationary.13Note that this does not impose
thatthe actualcapital stock and its hypotheticalfrictionlesslevel are equal on average,since the
errortermeit need not be mean zero. However,the partialirreversibilityframeworkindicatesthat
eit will be serially correlatedin a highly complex way. Any parsimoniousspecificationof these
dynamics should be viewed as an approximation,the quality of which we will investigateusing
simulatedinvestmentdatain the next section.
A basic error correctionrepresentationof the dynamic relationshipbetween logKit and
logKi*t, using equation
(3.2), would have the form
AlogKit = P AlogYit+ O(logYi,t-1 - logKi,t-1) + Ai + Bt + vit, (3.3)

where Ai and Bt are again unobservedfirm-specificand time-specific effects and vit is, at least
approximately,a serially uncorrelatederrorterm. A key propertyis that the coefficient 0 on the
errorcorrectionterm shouldbe positive, so thatfirmswith a capitalstock level below theirtarget
will eventuallyadjustupwardsand vice versa.
We use the approximation AlogKit ~
-• 6i, where Iit is gross investment and 6i
(lit/Ki,t-l)
is the (possibly firm-specific)depreciationrate.To test for the effect of uncertaintyon the impact
effect of demandshocks (the firstimplication),we add an interactiontermbetween a measureof
uncertainty(SDit) and currentsales growth(AlogYit). A negative coefficient on this interaction
term would indicatethatthe short-runresponseof investmentto demandshocks is indeed lower
at higher levels of uncertainty.To allow for other possible effects of uncertaintyon the level of
the capital stock in either the short run or the long run, we also consider furtherterms in both
the change (ASDit) and the level (SDit) of our measureof uncertainty.To test for non-linearity
11. See, for example, Hall, Mairesseand Mulkay(1999) and Bond, Harhoffand VanReenen (2007).
12. The representationtheoremof Engle and Granger(1987) shows thatthe dynamicrelationshipbetween two I(1)
series thatare cointegratedcan be formulatedas an errorcorrectionrelationship.
13. Both this specificationand the results in Bloom (2000) are based on a single productionunit with one type of
capital.To check that this provides an accurateapproximationfor our aggregatedfirm-leveldata, we confirmedthat log
capitalwas cointegratedwith log sales in our simulateddata,with a coefficient of 1-008 on log sales. In Sections 3.2 and
4.4 we also considerrelaxingthe restrictionin (3.2) thatthis coefficient is unity.

TABLE2
Samplecorrelationsin the simulateddata
lit/Ki,t-1 Ayit Apit SDit ait

Investmentrate, lit/Ki,t_1 1.000 0-823 0.618 0.081 -0-067
Sales growth, Ayit 1.000 0-395 0.018 -0-224
Demandgrowth, Apit 1.000 -0-018 -0-006
Standarddeviationof returns,SDit 1.000 0-645
Uncertainty,ait 1.000
Note: These arePearsoncorrelationcoefficientsof the relevantvariables(e.g. the correlation

of Ayit and Apit is 0-395) takenover the simulateddatafor 1000 firmsand 15 years.
responseof investmentto demandshocks(the secondimplication),we adda

in the short-run
higher-order in currentsalesgrowth(AlogYit)2.A positivecoefficienton thissquaredterm
term
wouldbe consistentwiththisimplication,indicatinga convexrelationship
betweeninvestment
and demandshocks,recallingthatour samplesare dominatedby observations on firmswith
positivegrossinvestment.
termsthengiveus anempiricalspecification
Theseadditional of theform
it = fl AlogYit + f3(SDit * AlogYit)
Ki,t-1 +-2(AlogYt)2
+O(logYi,t-I - logKi,t-1) + 71SDit+Y2 ASDit + Ai + i + Bt + vit. (3.4)
3.1. Testingour empiricalspecificationon simulateddata

To investigatewhetherthis econometricapproachcan detect the propertiesof short-runinvest-
ment dynamics highlighted in Section 2, we use our simulationmodel to generate data for a
panel of 1000 firms and 15 years. This allows us to consider whetherthis relatively simple dy-
namic econometricspecificationprovidesan adequateapproximationto the complex investment
dynamics suggested by models with partialirreversibilityand to comparespecificationsthat use
sales and a stock-returnsmeasure of uncertaintywith specificationsthat use the true underly-
ing demand and uncertaintyvariables.Sales (Yit) are generatedfrom the revenue function and
aggregated across productionunits and months. Monthly stock returnsare generated by ag-
gregating the value function across units and adding in monthly net cash flows (revenue less
investmentcosts). The within-yearstandarddeviationof these monthly returns(SDit) provides
our firm-level measure of uncertainty,which mimics the kind of measure used in our empiri-
cal analysis in Section 4. Table 2 reportsthe sample correlationmatrixfor key variablesin our
simulateddata-set.14This demonstratesthat the standarddeviation of monthly stock returnsis
positively correlatedwith the underlyingstandarddeviationof demandshocks (ait), supporting
the use of this as an empiricalmeasureof uncertainty.In what follows, we use lower cases to
denote naturallogarithms,so for example, yit = log Yit.
In Table 3 we present the results of estimating the augmentedECM of investmentusing
this simulatedfirm-levelpanel. In column (1) we firstreportOLS estimatesusing as explanatory
variablesthe annualmeasuresof the "true"demand(P) and uncertainty(u) variablesthat were
used to generatethese simulatedinvestmentdata.Ourtests detect significantheterogeneityin the
impact effect of demandshocks on firm-levelinvestment,dependingon the level of uncertainty,
and significantconvexity in the responseof investmentto demandshocks. We also find evidence
14. All the simulation data, actual data, and estimation code requiredto produce Tables 2-7 are available on
http://www.stanford.edu/-nbloom/and from nbloom@stanford.edu

TABLE3
Econometricestimationon the simulateddata
Dependentvariable:lit/Ki,t_1 (1) (2) (3) (4)

Estimationmethod OLS GMM OLS OLS
Type of datafor P and a True Empirical True True
Hartman-Abeleffects No No Positive Negative
Demandgrowth, Apit 0-395 0-539 0.387 0.416
(0-041) (0-083) (0-040) (0-040)
Demandgrowthsquared, 0-028 0.864 0-028 0.028
Ap2t
(0.005) (0-212) (0-004) (0-005)
Changein uncertainty,Aait -0-095 -0-042 -0-020 -0-755
(0-046) (0-019) (0-160) (0-161)
Uncertainty,ait 0.005 -0-080 0.373 -0-402
(0-021) (0-097) (0.080) (0-066)
Uncertaintyx demandgrowth,ait * Apit -0-441 -0-440 -1.500 -1.733
(0-108) (0-166) (0-368) (0-373)
DemandECM, (p - k)i,t_1 0.190 0.439 0.189 0.187
(0.008) (0-105) (0.008) (0.008)
Second-orderserial correlation(p-value) 0.185
Sargan-Hansentest (p-value) 0.856
Note: Standarderrorsare robustto arbitraryautocorrelationand heteroscedasticity.GMM coefficients are one-step

estimates.Columns(1), (3), and (4) estimateusing the underlying"true"demandand variancedata,while column (2)
estimatesusing the "empirical"proxies: sales (insteadof demand)and the standarddeviationof stock returns(instead
of demandvariance).The instrumentsused in column (2) are lags 2 and 3 of the variables Ki Ayit, ASDit, and
(y - k)it. Instrumentvalidity is tested using a Sargan-Hansentest of the overidentifyingrestrictions.Serialcorrelation
is tested using a Lagrangemultipliertest on the first-differencedresiduals(Arellano and Bond, 1991). To maintaina
constantsample across specificationswe use years 4-15 in all columns, providing 12,000 observationson a balanced
panel of 1000 firms.Implementationof Hartman-Abeleffects is describedin the text.
of "error-correcting" behaviour,with the actualcapital stock adjustingin the long run towardsa
targetthat is cointegratedwith its frictionless level. We find no evidence here that a permanent
increasein the level of uncertaintywould affect the level of the capital stock in the long run, but
thereis an indicationthatincreasesin uncertaintyreduceinvestmentin the shortrunin ways that
are not fully capturedby our multiplicativeinteractionterm.
Column(2) of Table3 uses insteadthe empiricalcounterpartsto the demandanduncertainty
variables,based on annuallevels of simulatedsales (Yit) and the within-yearstandarddeviation
of simulatedmonthly stock returns(SDit). As these variablesarejointly determinedwith invest-
ment decisions we treatthem as endogenousand reportGMM estimates.To mimic our empirical
analysis of real companydatamore closely, we also allow for the possibility of unobservedfirm-
specific effects here and estimatethis specificationin first differences.The instrumentsused are
the second and thirdlags of our simulatedinvestment,capital, sales, and uncertaintymeasures,
following Arellano and Bond (1991). A Sargan-Hansentest of overidentifyingrestrictionsdoes
not rejectthis specification,and thereis no significantevidence of second-orderserialcorrelation
in the first-differencedresiduals.While the parameterestimates are less precise in this case, we
again detect significantevidence thatuncertaintyinfluencesthe short-runresponseof investment
to demand shocks and that this response is convex. It should be noted, however, that this was
not always the case if we imposed simplerdynamic specificationsthat were rejectedby the test
of overidentifyingrestrictions(e.g. if we omit the errorcorrectionterm). This illustratesthe po-
tentialimportanceof controllingfor longer runinvestmentdynamicswhen testing the properties
of the short-runresponses to demandshocks. For other calibrationsof the simulationmodel we
found that alternativedynamic specificationsor instrumentsets may be required.The negative
coefficient on the interactionterm and the positive coefficient on the squaredterm, however,

were found consistentlyacross specificationsthatwere not rejectedby the test of overidentifying

restrictions.
Consideringthe magnitudeof this effect of uncertainty,we find that the predictedimpact
effect of sales growthon investmentratesincreasesby 79% when moving from the thirdquartile
to the first quartilein the distributionof measureduncertaintyand by 168%when moving from
the 90th percentile to the 10th percentile. These differences are quantitativelysimilar to those
that we estimateddirectlyfor the underlyingmodel in Section 2.3.
This suggests that our econometric tests have power to detect these propertiesof short-
run investmentdynamics, at least using this simulateddata-set.Interestingly,we also find that
the longer run capital stock adjustmentprocess is approximatedquite well by our errorcorrec-
tion specificationand that our GMM estimates using measuredsales and uncertaintyvariables
even providequantitativeestimatesof the effect of uncertaintyon short-runresponsesto demand
shocks that are in the right ballpark.
In columns (3) and (4) of Table 3 we confirmthat these propertiesof short-runinvestment
dynamicsare also found using two alternativespecificationsof our simulationmodel, which ap-
proximateHartman(1972) and Abel (1983) type effects of uncertaintyon 2the expectedMRPC.15
In column (3) we set the drift in the demandprocess 2u (or) = 004 + so that the expected
",
MRPC is increasingin uncertainty.As expected, this generatesa positive long-runeffect of the
level of uncertaintyon the level of the capital stock. Nevertheless, we can still detect the neg-
ative effect of uncertaintyon the short-runresponse of investmentto demand shocks and the
convex shape of these short-runresponses. In column (4) we set the drift 2 (at) = - O
0.04 2'
so that the expected MRPC is decreasing in uncertainty.This generates a negative long-run
effect of uncertainty on the level of the capital stock, but has little impact on either the
interactiontermbetween demandgrowthand uncertaintyor on our higher-orderdemandgrowth
term. This suggests, first, that our econometric tests of the propertiesof short-runinvestment
dynamics appearto be robust (at least to these modifications),and second, that the longer run
effects of uncertaintyare theoreticallyambiguousand need to be determinedempirically.This
echoes the discussions both in Leahy and Whited (1996), who outline a range of potentially
positive and negative effects of uncertainty,and in Abel and Eberly (1999), who note the
ambiguous long-run effects of uncertaintyon capital stock levels in a partial irreversibility
framework.
3.2. Simulationrobustnesstests
To assess the generality of our predictionson the uncertainty-demandgrowth interactionterm
and on the demandgrowthsquaredterm,we now investigatewhetherthese effects are found for
an alternativerevenuefunctionand for alternativetypes of adjustmentcosts.
15. In a competitivemodel with shocks to outputprices and a flexible factor(such as labour)the MRPC is convex
in demandconditions, so uncertaintyhas a positive impacton the expectedMRPC.For example, with a revenuefunction
R = ZKa Lb (where Z is a demandprocess, K is capital,and L is labour),afteroptimizingout labournet revenueequals
CZ1/(1-b)Ka/(1-b) (where C is a constant)and the MRPC equals Z1/(1-b)K(a+b-1)/(1-b). If Z is a geometric
Brownian process with drift and variance a, then so the expected
E[dZ/(1-b)/Zl/(1-b)] = ( +~ i t
t b,
growth of MRPC +
equals (p 1, which is in
increasing uncertainty.However, as Caballero (1991) notes, the
) and whether the underlying
sign of this effect is sensitive to assumptions
_ 1___ such as the degree of imperfectcompetition,
shocks are to prices or quantities.Underalternativeassumptionsthe MRPC can become concave in demandconditions,
with a negative impact of uncertainty.To qualitativelysimulatethese positive and negative Hartman-Abeleffects in our
linear homogeneous specification,we adjustour demanddrift term by +- -,
noting that the quantitativeeffects would
also dependon the exact convexity/concavityof the underlyingMRPCin demandconditions.

BLOOMET AL. UNCERTAINTYAND INVESTMENTDYNAMICS 403
TABLE4
Robustnesstests on the simulateddata
Dependentvariable:(Iit/Ki,tl) (1) (2) (3) (4) (5)
Estimationmethod OLS OLS OLS OLS GMM
Type of data for P and a True True True True Empirical
Adjustmentcosts Partial Fixed Quadratic All All
Revenuefunction CES Cobb- Cobb- Cobb- Cobb-
Douglas Douglas Douglas Douglas
Demandgrowth, Apit 0.400 0-586 0-486 0.378 0.630
(0-041) (0-093) (0.051) (0-039) (0.065)
Demandgrowthsquared,Ap2 0.029 -0-012 -0-004 0.011 0.403
(0-004) (0-031) (0.015) (0-004) (0-114)
Changein uncertainty,Aai t -0-389 - 1031 -0-048 -0-666 -0-064
(0-158) (0-283) (0-220) (0-141) (0-042)
Uncertainty,ait -0-006 -0-505 -1-216 0-033 0-101
(0-071) (0-131) (0-090) (0-066) (0-294)
Uncertaintyx demandgrowth, -1-566 1.766 -0-844 -1-791 -0-701
ait * Apit (0-373) (0-854) (0-427) (0-346) (0-294)
DemandECM term, (p - k)i,t_1 0.186 0.205 0-323 0.180 0-204
(0-008) (0-024) (0-020) (0-006) (0-098)
Second-orderserial correlation(p-value) 0.267
Sargan-Hansentest (p-value) 0.875
Note: Standarderrorsare robustto arbitraryautocorrelationand heteroscedasticity.GMM coefficients

are one-step estimates. Columns (1) to (4) estimate using the underlying"true"demand and variance
data,while column (5) estimates using the "empirical"proxies: sales (insteadof demand)and the stand-
arddeviationof stock returns(insteadof demandvariance).The instrumentsused in column (5) arelags
2 and 3 of the variables i. , Ayit, ASDit, and (y -k)it. Instrumentvalidityis tested using a Sargan-
Hansen test of the overidentifyingrestrictions.Serial correlationis tested using a Lagrangemultiplier
test on the first-differencedresiduals(Arellanoand Bond, 1991). To maintaina constantsample across
specificationswe estimateon years 4-15 in all columns (despitebeing able to estimateon years 2-15 in
the OLS estimation).
3.2.1. A CES specification. The simulationmodel and assumptionsrequireonly a super-

modular homogeneous unit revenue function, so we can replace the Cobb-Douglas revenue
function (2.1) with a functionof a CES aggregatorover the two types of capital
R(X, KI, K2) = Xa(Kf + K)Y (3.5)
The associated linear homogeneous revenue function is then defined as R(P, K1, K2)
P -Y (K + K2)7/f, where P = Xa/(1-). We set f = 0.5 and y = 0.8.
Column (1) of Table4 presentsOLS results for simulatedfirm-leveldata with this alterna-
tive CES specification,using the true demandand uncertaintyvariables.We again find that the
short-runresponseof investmentto demandshocks is convex and thathigheruncertaintyreduces
this impacteffect of demandshocks on investment.First-differencedGMMestimates,using sales
as a measure of demand and stock-returnvolatility as a measure of uncertainty,also yielded a
significantpositive coefficient on the sales growth squaredterm and a significant negative co-
efficient on the uncertaintyinteractionterm.16This suggests that our empiricaltests can detect
these effects on short-runinvestmentdynamicswith this alternativespecificationof the revenue
function.
16. Coefficients(standarderror)of 0.627 (0-132) on the sales growthterm and -1.452 (0-467) on the uncertainty
interactionterm.

3.2.2. General adjustment costs. A number of previous papers, including Abel and
Eberly (1994), Bloom (2006, 2007), and Cooper and Haltiwanger(2006) have noted that dif-
ferent forms of adjustmentcosts can have significantlydifferentimplicationsfor investmentbe-
haviour.Ourcore predictionsarebased on a model with partialirreversibilities,butin this section
we investigatewhetherthey are also found using two additionaltypes of adjustmentcosts: fixed
disruptioncosts and quadraticadjustmentcosts.
Fixed disruptioncosts: When new capitalis addedto the productionprocess some downtime
may result in a fixed loss of output,howeverlarge the investment.For example, the factory may
need to close for a fixed period while a refit is occurring.For the simulationwe assume that the
fixed cost of adjustmentfor either type of capital is 5% of annualsales, which is approximately
calibratedon a monthlybasis from the annualestimatesin Cooperand Haltiwanger(2006).
Quadratic adjustmentcosts: The costs of investmentmay also be related to the rate of
adjustmentwith highercosts for more rapidchanges, which we specify as Cquad,j j ( K-)2
for j = 1,2. Forthe simulationwe assumethat2j = 0-3 for both types of capital,againcalibrated
roughly on a monthlybasis from Cooperand Haltiwanger's(2006) annualestimates.17
Since both these adjustmentcosts arejointly homogeneousof degree one in (P, K1, K2) the
cost function C(P, K1, K2, I, I2) is also homogeneous, permittingthe same normalizationby
capital type 1 and the resultingacceleratednumericalsolution as outlinedin Section 2.2.
Column (2) of Table4 presentsOLS results for simulatedfirm-leveldata with fixed adjust-
ment costs only, againusing the truedemandand uncertaintyvariables.Interestingly,in this case
we find that higher uncertaintyhas the opposite effect on the impact effect of demand shocks
on investment.This suggests that the "cautionaryeffect" of uncertaintyon short-runinvestment
dynamicsis sensitive to the form of adjustmentcosts, even withinthe class of non-convexadjust-
ment costs. The reasonfor this positive effect is that,underfixed costs, investmentis undertaken
as a jump process with the level of investmentdeterminedso as to return - and to targetlev-
els between theirthresholds,ratherthanto hold them continuouslyat theirinvestment 2 thresholds
as underpartialirreversibility.When uncertaintyrises and the thresholdsmove furtherapart,this
targetlevel moves by less, so thatthe gap between the targetand the investmentthresholdgrows
and the amount of investmentrequiredto reach the target also grows. This positive impact of
uncertaintyon the level of investmentundertakenat each investingunit offsets the negativeeffect
of uncertaintyon the numberof investingunits, leading to a positive effect of uncertaintyon the
responseof investmentto demandshocks in our simulationwith fixed costs only. Since the mag-
nitudeof these opposingeffects is likely to be sensitiveto the exactparameterizationof the model,
the sign of this short-runeffect is probablyambiguousunder(pure)fixed costs. We also find no
significantnon-linearityin the responseof investmentto demandshocks in this experiment.
Column (3) of Table 4 reportsthe OLS results for a simulationwith quadraticadjustment
costs only. In this case we find a smallerresponseof investmentto demandshocks at higherlev-
els of uncertainty,but again no significantindicationof non-linearityin the short-runresponses.
Again these results suggest that these propertiesof short-runinvestmentdynamics are sensitive
to the type of adjustmentcosts. In this experimentwe also find a stronglong-runeffect of uncer-
taintyin reducingthe level of the capitalstock,18althoughwe note thatthis effect could be offset
by a positive Hartman-Abeltype effect of the kind consideredin Table3.
17. For simplicity we have assumedthatboth the fixed and the quadraticadjustmentcosts are identical for the two
types of capital, with no cross-effects. In experimentsallowing for differentlevels of these adjustmentcosts for the two
types of capital,we found qualitativelysimilarresults.Ourapproachcould allow for more generalspecificationsof these
adjustmentcosts, with cross-effects,but we leave this for futureresearch.
18. With fixed costs or partialirreversibilities,the value functionis linearoutsidethe centralregionof inaction,with
slope equal to the purchase/resaleprice of capital, so that the value function is concave only in the region of inaction.
With quadraticadjustmentcosts, the value functionis globally curved,therebygeneratinggreaterglobal concavity.
? 2007 The Review of Economic StudiesLimited

Finally,in columns (4) and (5) we reportthe resultsfor a simulationthat combines all three
types of adjustmentcosts, with the same parametervalues used previously. For both the OLS
resultsusing the "true"explanatoryvariablesin column (4) andthe first-differencedGMMresults
using the observableproxies in column (5), we find evidence that higher uncertaintymakes the
responseof investmentto demandshocks more cautious,and thatthis responseis convex, with a
proportionatelylargerresponseto largershocks. At least for this combinationof adjustmentcost
parameters,based on the evidence presentedin Cooperand Haltiwanger(2006), we find that the
propertiesof the short-runinvestmentdynamics seem to be dominatedby the effects of partial
irreversibilitythatwe highlightedin Section 2.
In other robustnesstests we also experimentedwith, first, changing the discount rate from
10%to 5%, and second, relaxingthe restrictionin oureconometricspecificationthatthe long-run
coefficient on log sales is unity, as in equation(3.2). The signs and statisticalsignificanceof the
coefficients on the additionaluncertaintyinteractionand squareddemand growth terms in our
augmentedECMs were robustin both cases, both in the OLS and in the first-differencedGMM
results.19
4. EMPIRICALRESULTSFOR COMPANYDATA
In this section we want to investigateif our theoreticalpredictionshold in real firm-leveldata.
We use firm-leveldatafor an unbalancedpanel of 672 publicly tradedU.K. manufacturingfirms
between 1972 and 1991. We use pre-1991 U.K. databecause the accountingregulationsrequired
firmsto reportinvestmentexpenditureconsistentlythroughoutthis period, togetherwith the net
book value of capitalfrom acquisitionof subsidiariesandrevenuefrom sales of fixed assets. This
enablesus to constructrelativelyaccuratemeasuresof bothinvestmentanddisinvestment.We use
data on publicly tradedcompanies because these allow us to constructmeasuresof uncertainty
from high-frequencystock marketreturnsdata.
4.1. Uncertaintymeasures
Although our formal model focuses on uncertaintyabout demand and productivityconditions,

our measure of uncertaintyis much broaderin scope. In reality, firms will be uncertainabout
a wide range of factors, including taxes, regulations,interest rates, wages, exchange rates, and
technologicalchange. In an attemptto captureall relevantfactorsin one scalarmeasure,we fol-
low the approachsuggestedby Leahy and Whited (1996) and use the standarddeviationof daily
stock returnsfor firmi in accountingyear t, denotedSDit. This providesa forward-lookingindi-
catorthatis implicitly weighted in accordancewith the impactof differentsourcesof uncertainty
on the firm'svalue.
A stock-returns-based measureof uncertaintyis also attractivebecause the dataare reported
at a sufficientlyhigh frequencyto use on an annualbasis. Forhomoscedasticdiffusionprocesses,
the varianceof the sample varianceis inversely relatedto the samplingfrequency (see Merton,
1980). Our sampling frequency of about 265 observationsper year should yield low sample
variance, so that movements in the measuredvarianceshould reflect changes in the underlying
process ratherthanextremedraws.
One possible concernaboutthis measureof uncertaintyis thatthe variabilityin stock market
returnsmay partlyreflect noise unrelatedto fundamentals(e.g. shareprice bubbles).We address
this by consideringa second measurethatnormalizesthe firm'sdaily sharereturnby the returnon
19. For the simulateddata with a 5% discount rate, a consistent finding was that the effect of uncertaintyon the
short-runresponseof investmentto demandshocks was largerthanwe found with a 10%discountrate.This is consistent
with the highervalue of real options at a lower discountrate.These results are availableon requestfrom the authors.

the FTSE All-Shareindex to eliminatethe effect of any aggregatestock marketbubbles.We also

consider using the within-yearstandarddeviationof the firm'smonthly stock returns.Although
estimates based on 12-monthlyobservationsare subject to more sampling variation,this will
reducethe impactof high-frequencynoise thatmay be presentin daily observations.
A differentconcernis whetherthe volatilityin stock returnswould reflectthe varianceof de-
mandor productivityshocks in ourunderlyingtheoreticalframework.We have addressedthis us-
ing our simulateddatain the previoussection wherewe findthateconometricspecificationsusing
this observableproxy can detect the impactof underlyinguncertaintyon investmentdynamics.
We have also comparedour stock-returnsmeasureto otherpossible proxies for uncertainty.
Using IBES data for U.K. firms, Bond, Moessner, Mumtaz and Syed (2005) reportthat stock-
returnsvolatility is positively correlatedto both the within-yearvariabilityof analysts' earnings
forecasts and the cross-sectionaldispersionacross forecasts made by differentanalysts for the
same firm.
Finally, we note that our empiricalfindingon the relationshipbetween uncertaintyand the
impact effect of demand growth is qualitativelysimilar to that obtained by Guiso and Parigi
(1999), who used cross-sectional survey data on managers' subjective distributionsof future
demand growth to estimate the variance of firm-level demand shocks for a sample of Italian
firms. This suggests that this propertyof short-runinvestmentdynamics can be detected using
differentempiricalmeasuresof uncertainty.
4.2. Investmentand other accountingdata

We obtainedcompany accountsdata, as well as data on stock returns,from Datastream.Invest-
ment in fixed capital assets is measurednet of revenuefrom asset sales. Ourcapital stock meas-
ure is benchmarkedusing the book value of the firm's stock of net fixed assets and subsequently
updatedusing the investmentdata in a standardperpetualinventoryformula.Real sales are ob-
tained from data on nominal sales using the aggregateGDP deflator.Cash flow is measuredas
reportedpost-tax earningsplus depreciationdeductions.Furtherdetails are providedin the Data
Appendix.
4.3. Estimationresults
Our main econometric results are estimated using the system GMM proceduredeveloped by
Arellano and Bover (1995) and Blundell and Bond (1998). This combines a system of equations
in first differencesusing suitablylagged levels of endogenousvariablesas instruments,as in the
basic first-differencedGMM estimator(see Arellano and Bond, 1991), with equationsin levels
for which lagged differencesof endogenousvariablesare used as instruments.Unobservedfirm-
specific effects areeliminatedfromthe first-differencedequationsby the transformation.The key
requirementis thatthe additionalinstrumentsused in the levels equationsshouldbe uncorrelated
with the unobservedfirm-specificeffects in the investmentequation, which is tested using the
Sargan-Hansentest of overidentifyingrestrictions.The advantageis that, if these additionalin-
strumentsare valid, the system GMM estimatorshouldhave greaterefficiency and smallerfinite
sample bias than the correspondingfirst-differencedGMM estimator.The reportedresults treat
both sales and stock-returnsvolatilityas endogenousvariables,with the precise instrumentsused
noted in the tables. Similarresults were found using a range of alternativeinstrumentsets, and
our main findings concerningthe short-runeffects of sales growthand uncertaintyon company
investmentwere also found using the first-differencedGMM estimator.
Our main specificationis based on equation(3.4), with currentand lagged cash flow vari-
ables as additionalcontrols.Such termsare often found to be informativein micro-
(Cit/Ki,t-1)
econometric investment equations and may reflect either financing constraints (see Fazzari,

TABLE5
Econometricestimatesusing U.K.companydata
Dependentvariable:(lit /Ki,t-1 ) (1) (2) (3) (4) (5)

Sales growth(Ayit) 0.259 0.151 0.382 0.400 0.413
(0.072) (0-059) (0-136) (0-139) (0-139)
Cash flow ) 0.206 0.263 0.260 0-255 0.272
(Cit/Ki,t-1
(0-135) (0-132) (0-124) (0-126) (0-125)
Lagged cash flow (Ci,t-1/Ki,t-2) 0.303 0.269 0.272 0.288 0.273
(0-086) (0-082) (0-075) (0-075) (0-076)
Errorcorrectionterm (y - k)i,t-1 0.062 0-056 0.054 0-054 0.053
(0-030) (0.030) (0-026) (0-026) (0-026)
Sales growthsquared(Ayit)2 0.481 0.513 0-494 0.500
(0-175) (0-152) (0-150) (0-151)
Changein uncertainty(ASDit) -0-023 -0-012
(0-012) (0.008)
Lagged uncertainty -0-015
(SDi,t_1) (0-011)
Uncertaintyx sales growth -0-162 -0-165 -0-167
(SDit * Ayit) (0-067) (0-068) (0-068)
Goodness of fit-Corr(I/K, I/K)2 0.259 0.287 0.285 0.285 0-307
Serial correlation(p-value) 0.047 0.102 0.069 0.078 0.091
Sargan-Hansen(p-value) 0.510 0-709 0.699 0.629 0.560
Note: One-stepcoefficients and standarderrorsrobustto autocorrelationand heteroscedasticityare reported.The num-

ber of observationsin all columns is 5347, using an unbalancedpanel of 672 firms over 1973-1991. A full set of year
dummiesis includedin all specifications.Estimationuses a system GMMestimator(see Blundell andBond, 1998) com-
puted in DPD98 for Gauss. The instrumentsused in columns (3)-(5) are, in the first-differencedequations:
Kit-)
Ayi,t-2 and Ayi,t-3, (t), (y -k)it-2 and(y - k)it-3, andSDit-2, SDit-3,
and( i-)
and SDi,t-4 and in the levels equations:
(i'-)and
A t
, AAyi,t-1, AA and AASDi,t-1.
,AA(y-k)i,t_1,
Columns (1) and (2) use this instrumentset but with the uncertaintyvariablesexcluded. Instrumentvalidity is tested
using a Sargan-Hansentest of the overidentifyingrestrictions.Second-orderserial correlationin the first-differenced
residuals is tested using a Lagrangemultipliertest (Arellano and Bond, 1991). The goodness-of-fit measure is the
squaredcorrelationcoefficientbetween actualand predictedlevels of the dependentvariable.
Hubbardand Petersen, 1988), expectationsof futuredemandgrowth,or profitability(see Bond,

Klemm, Newton-Smith, Syed and Vlieghe, 2004) or more generally measurementerrors or
misspecifications(see, for example, Erickson and Whited, 2000; Cooper and Ejarque,2003).
In our case these cash flow terms are statisticallysignificantand are requiredto obtainempirical
specificationsthatarenot rejectedby the test of overidentifyingrestrictions.However,as reported
below, our main resultson investmentdynamicsare robustto theirexclusion.
Column (1) of Table 5 reportsresults for a basic linear errorcorrectionmodel with these
additionalcash flow terms. We find that the key coefficient on the errorcorrectionterm is cor-
rectly signed and statisticallysignificant,suggesting that in the long run companies adjusttheir
capital stocks towardsa target that is proportionalto real sales. We also find an impact effect
of real sales growth that is positive and statisticallysignificant, althoughconsiderablysmaller
than the long-runelasticity of unity, and significanteffects from the additionalcash-flow terms.
Thereis marginallysignificantevidence of second-orderserialcorrelationin the first-differenced
residualsin this basic specification,althoughthe Sargan-Hansentest does not reject the validity
of the overidentifyingrestrictions.A simple goodness-of-fitstatisticalso suggests thatthis model
has reasonableexplanatorypower for firm-leveldataof this kind.20
20. We reportthe squaredcorrelationcoefficient between actual and predictedlevels of the investmentrate. This
squaredcorrelationmeasureis equivalentto the standardR2 in an OLS regression,and is recommendedas a goodness-
of-fit measurefor instrumentalvariableregressionsby, for example,Windmeijer(1995).

Column (2) of Table5 adds a squaredtermin currentreal sales growthto this basic specifi-
cation. In line with our resultsfor the simulateddataunderpartialirreversibilityin Section 3, we
find significantpositive coefficientson both the level andthe squareof real sales growth.Column
(3) adds a range of uncertaintyterms to this extended errorcorrectionspecification.The main
result of interest here is the significantnegative coefficient on the interactionterm. The linear
uncertaintyterms (the change in uncertaintyand the lagged level of uncertainty),in contrast,are
found to be only weakly significant,with a joint test of their exclusion from the specificationin
column (3) not rejected(p-value= 0-17). We includethese termsherepartlyto ensurethatthe sig-
nificantcoefficient on the interactiontermis not the resultof omittingrelevantlinearuncertainty
termsand partlyto investigatewhetherthereis significantevidence of a long-runeffect of uncer-
tainty on capital accumulation.The insignificanceof the lagged level of uncertaintyin column
(3) formallyrejects the presence of such a long-runeffect, althoughthe imprecisionwith which
we estimatethis coefficientsuggests thatthis test may not be very powerful.21Omittingthis term
in column (4) results in an insignificantcoefficient on the short-runchange in uncertaintyterm,
which we also omit from our preferredparsimoniousspecificationin column (5). Thus the only
effect of uncertaintyon companyinvestmentbehaviourthat we can detect with a high degree of
statisticalconfidenceis the interactionwith the impacteffect of currentreal sales growth.22
Table 6 investigates this interactioneffect further.Here we decompose our stock-returns
measure of uncertainty(SDit) into three components-a macroeconomiccomponent,common
to all firms in a particularyear a time-invariantfirm-specificcomponent (SDi); and an
(SD/);
idiosyncratictime-varyingcomponent(SDit = SDit - SDt - SDi). Columns (1)-(3) include in-
teractionsbetween real sales growth and each of these uncertaintyvariablesindividually,while
column (4) includes all threeinteractiontermsjointly.
The interactionbetween firm-levelreal sales growthand a purely macroeconomicmeasure
of uncertainty,includedin column (1) of Table6, is the least informativeof our threevariables.23
The interactionwith a time-invariantfirm-specificmeasure of uncertainty,reportedin column
(2), is only weakly significant,while columns (3) and (4) show that it is the interactionbetween
sales growth and the idiosyncratictime-varyingcomponent (SDit) of our uncertaintymeasure
thatis most informative.However,because the coefficientson the remaininginteractiontermsin
column (4) areestimatedimprecisely,we can easily acceptthe restrictionof common coefficients
on these threeinteractions,as imposed in our preferredempiricalspecification.
4.4. Robustnesstests
We conducteda numberof robustnesstests, some of which arereportedin Table7. In column (1)
we omit the cash-flow variables,which causes the test of overidentifyingrestrictionsto reject,
but does not affect the sign or the significanceof the coefficientson the interactiontermbetween
uncertaintyand sales growthandon the squaredsales growthterm.In column (2) we adda further
interactionwith firm size, defininga "big firm"dummyvariableBIGit that takes the value 1 for
observationswith real sales above the sample median and 0 otherwise. Ourresult indicates that
the effect of uncertaintyon the impact effect of sales growth on investmentis not significantly
differentbetween the smaller and larger firms within our sample. The point estimate suggests
that this effect may be smallerfor the relativelylarge firms.One possible explanationis that our
21. That is, our results do not rule out the possibility of an economically significantnegative long-run effect of
uncertaintyon capital accumulation,althoughwe cannotconfirmthe presenceof such an effect with any confidence.
22. Bloom and Van Reenen (2002) show a linked finding that higher uncertaintyreduces the responsiveness of
firms' productivityto new patents.
23. The limited informationthat we find in macroeconomicas opposed to microeconomicvariationin our uncer-
tainty measure may help to explain why annualtime-series studies of aggregateinvestmentdata have often not found
significanteffects of uncertaintyvariables.

TABLE6
Separatingtime,firm, and residual variationin uncertainty
Dependentvariable:(lit/Ki,tl) (1) (2) (3) (4)
Sales growth(Ayit) 0.127 0-141 0.474 0.499
(0-052) (0-053) (0-182) (0-184)
Cash flow (Cit/Ki,tl) 0.270 0.263 0.287 0.280
(0-124) (0-127) (0-122) (0-124)
Lagged cash flow (Ci,t-1/Ki,t-2) 0-261 0.270 0.264 0-273
(0-079) (0-080) (0-076) (0-077)
Errorcorrectionterm (y - k)i,t_1 0.054 0.056 0.047 0.049
(0-027) (0-027) (0-026) (0-026)
Sales growthsquared(Ayit)2 0.497 0-507 0.534 0.537
(0-170) (0-157) (0-148) (0-162)
Time uncertaintyx sales growth 0-016 -0-051
(SDt)* (Ayit) (0-150) (0-136)
Firmuncertaintyx sales growth -0-130 -0-136
(SDi) * (Ayit) (0-105) (0-107)
Residualuncertaintyx sales growth -0-225 -0-230
(SDit) * (Ayit) (0-102) (0-103)
Goodness of fit-Corr(I/K, IK)2 0.307 0.298 0.311 0.288
Second-orderserial correlation(p-value) 0.096 0.094 0.132 0.106
Sargan-Hansen(p-value) 0.399 0.490 0-383 0-452
Note: One-step coefficients and standarderrorsrobustto autocorrelationand hetero-

scedasticityare reported.The numberof observationsin all columns is 5347, using an
unbalancedpanelof 672 firmsover 1973-1991. A full set of year dummiesis included
in all specifications.Estimationuses a system GMMestimator(see Blundell andBond,
1998) computedin DPD98 for Gauss. The instrumentsused in all columns are, in the
first-differencedequations: and Ayi,t-3,(
(Kt-3 )and t_4 'Ayi,t-2 Ki,--3
and and (y -- kni
), (y k)i,t-2
and (y - and
and
k)i,t-3,SDit, Sni,
SD,t-3,
and
SDi,t-4
and
(Ci't-3
in the levels equations: A Ki ,A AA( and
A ASDi,t_1. Instrumentvalidity is tested Ayi,t_-1,
a ,AA(y-k)i,t-2,
test of the overiden-
using Sargan-Hansen
tifying restrictions.Second-orderserial correlationin the first-differencedresidualsis
tested using a Lagrangemultipliertest (Arellanoand Bond, 1991). The goodness-of-fit
measure is the squaredcorrelationcoefficient between actual and predictedlevels of
the dependentvariable.
stock-returnsmeasuremay be a noisier proxy for the underlyinguncertaintyin the case of larger

firmsdue to the effect of conglomeration.
In column (3) of Table7 we use an alternativemeasureof uncertaintyconstructedafternor-
malizing each firm's stock returnsby the returnon the FTSE All-Share index for the same day.
This measuregives a slightly largerand more precisely estimatedcoefficient on the interaction
term than our basic results, possibly because some of the general stock marketnoise has been
removed from this measureof uncertainty.In column (4) we use the within-yearstandarddevi-
ation of monthly stock returns(not normalized),ratherthan daily stock returns,to generatethe
uncertaintymeasure.Ourresults here are qualitativelysimilar,but in this case the coefficient on
the interactionterm is slightly smaller and less significant.This may be partlydue to the greater
sampling variance that results from the lower monthly sampling frequency,24suggesting that
higher frequencystock-returnsdata are valuablefor obtaininga more powerfultest.
24. Switching from daily to monthly returnsdata is expected to increase the sampling varianceof SDit fivefold.
The monthly (weekly) measure of uncertaintyhas a correlationcoefficient with the daily measure of 0.784 (0-900).
Using the weekly uncertaintymeasure,the coefficient (standarderror)on the uncertainty-salesgrowthinteractionterm
was estimatedto be -0-145 (0-082), aboutmid-way between the estimatesusing the daily and monthlymeasures.

TABLE7
Robustnesstests on U.K.companydata
Dependentvariable:(Iit/Ki,tl) (1) (2) (3) (4) (5)

Experiment No cash Size FTSE Monthly Leverage
flow splits normed returns adjusted
Sales growth(Ayit) 0.509 0.379 0-464 0.369 0.443
(0-121) (0-137) (0-153) (0-165) (0-119)
Cash flow (Cit/Ki,tl) 0.283 0.282 0.289 0.306
(0-124) (0-125) (0-127) (0-120)
Lagged cash flow (Ci,t-1/Ki,t-2) 0.272 0.272 0.266 0.257
(0-076) (0-075) (0-077) (0-073)
Errorcorrectionterm (y - k)i,t-1 0.163 0.052 0.052 0.048 0.060
(0-025) (0-026) (0.026) (0-026) (0-028)
Sales growthsquared(Ayit)2 0.496 0.479 0.462 0-480 0.557
(0-172) (0-151) (0-147) (0-154) (0-156)
Uncertaintyx sales growth -0-142 -0-185 -0-196 -0-145 -0-278
(SDit * Ayit) (0-065) (0-069) (0-075) (0-082) (0-087)
Big x uncertaintyx sales growth 0-082
(BIGit * SDit * Ayit) (0-060)
Serial correlation(p-value) 0.049 0.056 0.080 0-091 0.064
Sargan-Hansen(p-value) 0.010 0.531 0-504 0.682 0.662
Notes: One-stepcoefficientsandstandarderrorsrobustto autocorrelationandheteroscedasticity

are reported.The numberof observationsin all columns is 5347, using an unbalancedpanel of
672 firms over 1973-1991. A full set of year dummies is included in all specifications.The
dummy variableBIGit indicatesreal sales above the sample median.The uncertaintymeasure
in column (5) has been multipliedby the ratioequity/(equity+ debt). Estimationuses a system
GMMestimator(see BlundellandBond, 1998) computedin DPD98 for Gauss.The instruments
usedin all columnsare,in the first-differenced
equations: Ayi,t-2
(K3)and(-i
and Ayit-3, ( Kit-3- )and (Kit ) (y -k)i,t-2 and and SDit-2, SDi t-3, and
S i i ' (y-k)i,t-3, '
' '
SD,t-4; and in the levels equations: A( A Ayi,t AA(Ct
A ,AA(y-k)i,t-1,
and A ASDi,t-1. Instrumentvalidityis tested,t-2
using a Sargan-Hansentest of the overidentifying
restrictions.Second-orderserial correlationin the first-differencedresiduals is tested using a
Lagrangemultipliertest (ArellanoandBond, 1991). The goodness-of-fitmeasureis the squared
correlationcoefficientbetween actualand predictedlevels of the dependentvariable.
In column (5) of Table 7 we implement an adjustmentfor financial leverage, following

Leahy and Whited (1996), to eliminatethe effect of gearingon the variabilityof stock returns.25
Again we find thatour key resultson the propertiesof short-runinvestmentdynamicsare robust.
In this case we find that the coefficient on the interactionwith sales growth is largerand more
significant,possibly because controllingfor leveragereduces some of the measurementerrorin
our proxy for uncertainty.
We also consideredspecificationswith the lagged level of log sales as an additionalexplana-
tory variable;togetherwith the includederrorcorrectionterm,this relaxes the restrictionthatthe
long-runelasticity of capitalwith respectto sales is unity.This additionalterm was insignificant
in all cases, andour resultson short-runinvestmentdynamicswere completelyrobustto its inclu-
sion. We also experimentedwith a range of additionalnon-linearand interactionterms, none of
which was found to be statisticallysignificantin our sample. For example, we included interac-
tions of our measureof uncertaintywith squaredsales growth,cash flow, and the errorcorrection
term.Thejoint Waldtest for the exclusion of these threetermsgave a X2(3) statisticof 4-42, with
a p-value of 0.219. Finally, we also investigatedwhetherthe coefficient on our interactionterm
25. This is done by multiplying SDit by the ratio of equity to (equity + debt), with equity measuredusing the
marketvalue of shares(ordinaryand preference)and debt measuredusing the book value of all long-termdebt.

6.0 - 10thPercentileof uncertainty
25thPercentileof uncertainty
4.0-
75th Percentileof uncertainty
2.0-
Ca
0.0-
0 2 4 6 8 10
Years after the sales shock
FIGURE 2
Investmentresponseto a sales shock at differentlevels of uncertainty,U.K. firm-leveldata
was largeror more significantfor firmsin industrieswhere marketpower is likely to be greater

(as proxiedby concentrationratios,tradebarriers,etc.). An implicationof real options theoryis
thatthis effect of uncertaintyshouldbe strongerfor firmswith more marketpower.We found no
evidencethatthis was the case, althoughit could be thatourindustry-levelproxies areinadequate
measuresof the firm'smarketpower.
5. QUANTIFYINGTHE IMPACTOF UNCERTAINTY

The results presentedin the preceding section detect a statisticallysignificanteffect of higher
uncertaintyin dampeningthe response of companyinvestmentto demand shocks. To evaluate
the size of this effect we conducteda simple simulationusing the model in column (5) of Table5,
in which we trackthe predictedresponse of investmentand the capitalstock to an unanticipated,
permanent2.5% increase in real sales.26 Figure 2 plots the predictedresponse of investment
ratesfor observationsat differentlevels of uncertainty,highlightingthe large "cautionary"effect
of higheruncertaintyon the short-runinvestmentresponse. Here we find that moving from the
third quartileto the first quartilein the distributionof our measure of uncertaintydoubles the
impact, while moving from the 90th percentile to the 10th percentile increases it by fourfold.
This substantialimpact of uncertaintyis similar to the findings from our calibratedsimulation
model reportedin Section 2.3, suggesting that an effect of this size is consistent with a real
options explanation.
This indicatesthat increases in uncertaintyaroundmajor shocks, like September11, 2001
and the 1970's oil shocks, could seriouslyreduce the responsivenessof investmentto monetary
or fiscal policy.27Over the longer term these short-runeffects are slowly cancelled out due to
the cointegrationbetween capital and sales, as illustratedin Figure 3, but our estimates suggest
26. See Bloom, Bond and Van Reenen (2003) for more details of these and furthersimulations.The exact size of
the sales shock makesrelativelylittle differenceto the results.
27. For comparison,the increase in averageuncertaintyfor our sample firms after the 1973 oil crisis is similarin
magnitudeto the increasefrom the firstquartileto the thirdquartileof our sampledistribution.

25th Percentileof uncertainty
1.01 -
1.00 - / 50th Percentileof uncertainty
75th Percentile
ofuncertainty
Percentileof uncertainty
1.00
-905h
0 2 4 6 8 10
Yearsafterthe sales shock
FIGURE 3
Capitalstock responseto a sales shock at differentlevels of uncertainty,U.K. firm-leveldata
that the "short-run"effects persist for a significantperiod. Even after 10 years there is still a
noticeable differencebetween the predictedincreasesin capital stocks, in response to the same
demandshock, at differentlevels of uncertainty.
6. CONCLUSIONS
This paperdevelops two implicationsof partialirreversibilityfor the short-rundynamics of in-
vestment. First, investmentwill respond more cautiously to a given demand shock at higher
levels of uncertainty(due to wider thresholdsfor the zone of inaction), and second, investment
will have a convex response to positive demandshocks (due to aggregationand supermodular-
ity). We confirmthese implicationsusing numericalmethodsto solve a model with two types of
capital, a rich mix of adjustmentcosts (partialirreversibility,quadratic,and fixed), time-varying
uncertainty,alternativefunctionalforms for the revenuefunction,and aggregationover time and
productionunits. We propose and evaluatean econometricspecificationthat is designed to test
for these propertiesof short-runinvestmentdynamicsusing firm-leveldata.We reportevidence
that both the "cautionary"and the "convexity"effects are found using a measureof uncertainty
based on stock-returnsvolatility for a large panel of manufacturingfirms.Throughboth numer-
ical and econometric simulationswe show that these effects are economically important-the
investmentresponse to a demandshock is doubledby moving from the thirdquartileto the first
quartilein the distributionof our measure of uncertaintyand quadrupledby moving from the
90th to the 10thpercentile.
This indicatesthatthe one standarddeviationincreasein measuresof uncertaintyobserved
aroundmajorshocks, like September11, 2001 and the 1970's oil shocks, could seriouslyreduce
the responsivenessof investmentto subsequentmonetaryor fiscal policy. While we do not model
the behaviourof labourdemand,the existence of similarlabourhiringand firingcosts would im-
ply thathigheruncertaintywould also make firmsmore cautiousin theiremploymentresponses.
This is importantas policy-makerstypicallywantto respondto majorshocks, but the behavioural
responses to any given policy stimulusmay be much lower thannormalin these periods of high
uncertainty.

The empiricalresults indicatethatthe short-runinvestmentdynamicsfor large manufactur-

ing firms are consistent with the predictionsof a partialirreversibilitymodel in which higher
uncertaintyreduces the impact effect of demandshocks on investment.Of course, there may be
other explanationsthat could account for the same patternsin company investmentdynamics.
One possibility is thatfirms subjectto greateruncertaintymay place less weight on recent infor-
mation in updatingtheir expectationsof futuregrowthprospects.Discriminatingbetween these
and other explanationsfor our empirical findings presents an interestingchallenge for future
research.
In future work we plan to build on this researchin at least three furtherdirections. First,
by looking at the implicationsof uncertaintyfor adjustingother factors of production,such as
labour,R&D, and informationand communicationtechnologies. Second, by moving beyond our
calibrationof the micro-modelto undertakea full simulatedmethodof momentsestimationof the
adjustmentcost parametersundertime-varyinguncertainty,multiple factors of production,and
extensive aggregation.Finally, by using this approachto investigatethe impacts of uncertainty
on both the level and the distributionof micro- and macro-activity.
APPENDIX.DATAAPPENDIX
The companydataare takenfrom the consolidatedaccountsof manufacturingfirmslisted on the U.K. stock market.
We deleted firms with less than three consecutive observations,brokethe series for firmswhere accountingperiodsfell
outside the range300-400 days (due to changes in yearends), and excludedobservationsfor firmswherethere arejumps
of greaterthan 150%in any of the basic variables.These dataare obtainedfrom the Datastreamonline service.
Investment(I): Totalnew fixed assets (DS435) less sales of fixed assets (DS423).
Capital stock (K): Constructedby applying a perpetualinventoryprocedurewith a depreciationrate of 8%. The
startingvalue was based on the net book value of tangiblefixed capital assets (DS339) in the firstobservationwithin our
sample period, adjustedfor previousinflation.Subsequentvalues were obtainedusing accounts data on investmentand
asset sales and an aggregateseries for investmentgoods prices.
Sales (Y): Totalsales (DS104), deflatedby the aggregateGDP deflator.
Cashflow (C): Net profits(earnedfor ordinary,DS 182) plus depreciation(DS 136).
Uncertainty(a): The computationof this variableis describedin the text. For each companywe take the daily stock
marketreturn(DatastreamReturnsIndex, RI). This measure includes on a daily returnsbasis the capital gain on the
stock, dividendpayments,the value of rightsissues, special dividends,andstock dilutions.We then computethe standard
deviationof these daily returnson a year-by-yearbasis, matchedprecisely to the accountingperiod.We trimthe variable
so thatvalues above five are set equal to five. The results are robustto droppingthese 10 observations.
Acknowledgements. The authorswould like to thankin particulartwo anonymousrefereesandalso JeromeAdda,

ManuelArellano,OrazioAttanasio,RichardBlundell, Russell Cooper,EvrenCubrukgil,JasonCummins,Janice Eberly,
Domenico Lombardi,Costas Meghir, Steve Nickell, MurtazaSyed, Toni Whited, and FrankWindmeijer.The financial
supportof the ESRC (GrantR000223644) is gratefullyacknowledged.
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The Review of Economic Studies, Ltd.

Uncertainty and Investment Dynamics

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First version receivedFebruary2001; final version accepted September2006 (Eds.)

This papershows that with (partial)irreversibilityhigher uncertaintyreduces the responsivenessof

This content downloaded from 128.235.251.160 on Wed, 28 Jan 2015 20:47:57 PM

Previousresearchhas shownthataggregationdoes not eliminatethe impactof lumpymicro-

? 2007 The Review of Economic Studies Limited

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cautious.This suggests thatfirmswill generallybe less responsiveto monetaryand fiscal stimuli

2.1. Aggregationandfirm-level investment

? 2007 The Review of Economic Studies Limited

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Note: Firm-level data (6019 annual observations)from Extel and

productionunits experience idiosyncraticunit-level productivityshocks as well as a common

4. Supermodularityis a generalconceptfor complementarity.A functionf : Rn - R is definedas supermodularif

@ 2007 The Review of Economic Studies Limited

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R(X, K1, K2) = Xy Ka Kf2, (2.1)

R(X, K1, K2) = R(P, K1, K2) (2.2)

at = at- -1+ P (a * - at -1) + a Wt, Wt , N(0, 1). (2.5)

PtF PF_ + () + aVtF), VF N(0, 1). (2.6)

5. In the U.K. Census of Productionmicro-data,the averagesize of a manufacturingproductionunit is about20

@ 2007 The Review of Economic Studies Limited

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The two types of capitalarecostly to adjust.We startby modellingonly partialirreversibility

t) = max R(Pt*, 1 + I, Kt(1+

@ 2007 The Review of Economic Studies Limited

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2.3. Investigatingthe theoreticalimplications

? 2007 The Review of Economic Studies Limited

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in our simulatedfirm-leveldatadespite extensive aggregationacross the two types of capital,the

@ 2007 The Review of Economic StudiesLimited

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widely used in recentempiricalstudiesof companyinvestmentbehaviour.11Bloom (2000) shows

logKit = logKit + eit, (3.1)

logKi*t =logYit + A? + Bt, (3.2)

AlogKit = P AlogYit+ O(logYi,t-1 - logKi,t-1) + Ai + Bt + vit, (3.3)

@ 2007 The Review of Economic Studies Limited

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lit/Ki,t-1 Ayit Apit SDit ait

Note: These arePearsoncorrelationcoefficientsof the relevantvariables(e.g. the correlation

responseof investmentto demandshocks(the secondimplication),we adda

3.1. Testingour empiricalspecificationon simulateddata

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Dependentvariable:lit/Ki,t_1 (1) (2) (3) (4)

Note: Standarderrorsare robustto arbitraryautocorrelationand heteroscedasticity.GMM coefficients are one-step

@ 2007 The Review of Economic StudiesLimited

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were found consistentlyacross specificationsthatwere not rejectedby the test of overidentifying

? 2007 The Review of Economic Studies Limited

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Note: Standarderrorsare robustto arbitraryautocorrelationand heteroscedasticity.GMM coefficients

3.2.1. A CES specification. The simulationmodel and assumptionsrequireonly a super-

R(X, KI, K2) = Xa(Kf + K)Y (3.5)

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? 2007 The Review of Economic StudiesLimited

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Although our formal model focuses on uncertaintyabout demand and productivityconditions,

? 2007 The Review of Economic Studies Limited