1. Nick Bloom, Macro Topics, Spring 2009 1 Comments on: “Investment and Employment Dynamics in the Short-Run and the Long-Run”, Avinash Dixit, OEP (1997) Why I chose this paper: Very clearly written paper which pushed the intuition and relegates the details to other texts These models of adjustment costs in multiple dimensions are important in aggregate setting as the generate distributions and interesting responses (as we’ll see). EG: Prices Employment Consumption (housing) Share trading

2. Nick Bloom, Macro Topics, Spring 2009 2 Comments on: “Investment and Employment Dynamics in the Short-Run and the Long-Run”, Avinash Dixit, OEP (1997) Good framework for micro to macro: distribution of units: across this space reflects history shifts in this distribution: productivity shock shifts in the thresholds: regulations, expectations, uncertainty etc

3. Nick Bloom, Macro Topics, Spring 2009 3 Nick Bloom Investment and Uncertainty

4. Nick Bloom, Macro Topics, Spring 2009 4 What are the real options models predictions? Investment and hiring/firing will be lumpy: Evidence from Micro Data (Davis and Haltiwanger, 1992) Investment and hiring/firing will respond slowly to shocks: Wide range of evidence from micro and macro data Investment and hiring/firing response effected by adjustment costs No direct evidence that I know of (Bertola & Bentolila, 1990) Investment and hiring/firing response effected by uncertainty: Will discuss this today…

5. Nick Bloom, Macro Topics, Spring 2009 5 John Leahy and Toni Whited (1996) “The Effects of Uncertainty on Investment: Some stylized facts” Journal of Money, Credit and Banking

6. Nick Bloom, Macro Topics, Spring 2009 6 Overview Panel estimation of the effect of uncertainty on investment The fundamental idea was to: Use yearly volatility of daily returns of stock as a measure of uncertainty (σ i,y ≈ Σ d (r i,y,d 2 ) where r i,y,d is the stock returns for firm i, in year y on day d) Estimate yearly firm investment as a function of this Use firm and year controls to try and deal with other omitted variables Use GMM to try to deal with exogeneity An important paper: (i) First general test of investment-uncertainty literature (ii) Good econometrics – GMM and panel estimation (ii) Used interesting data – firm returns variance

7. Nick Bloom, Macro Topics, Spring 2009 7 Many cites - the rewards for being first…

8. Nick Bloom, Macro Topics, Spring 2009 8 Basic results Uncertainty reduces investment Covariance has no impact Tobin’s Q controls removes uncertainty effects, but note: Tobin’s Q also not significant Tobin Q = Marginal Q both PC & CRS hold, real options assumes either PC or CRS does not hold

9. Nick Bloom, Macro Topics, Spring 2009 9 Message is no large direct impact of uncertainty (at yearly frequency) Good paper – how could you build on this: Theory – take a structural approach. No link with theory Use Dixit & Pindcyk (1994), Abel & Eberly (1996) Identification – everything moves together so not clear what is identifying what (GMM is no magic bullet) Data – better measures of uncertainty, for example use implied volatility (forward looking) or a direct measure

10. Nick Bloom, Macro Topics, Spring 2009 10 Luigi Guiso and Giuseppe Parigi (1999) “Investment and Demand Uncertainty” Quarterly Journal of Economics

11. Nick Bloom, Macro Topics, Spring 2009 11 Overview Paper also estimates the effect of uncertainty on investment Contribution is a great uncertainty measure – a survey of firms distribution of demand growth expectations Used to generate a mean and variance of expected demand So can estimate effects of variance controlling for the mean The authors basically persuade the BOI to run this – ingenious! Also had a range of tests of other implications of the real options theory – so much closer to the theory

12. Nick Bloom, Macro Topics, Spring 2009 12 The rewards for ingenious data organisation…

13. Nick Bloom, Macro Topics, Spring 2009 13 Basic setup The paper is heavily (and appropriately) orientated around the description of the empirical uncertainty measure One important innovation is they changed the specification for the uncertainty from levels to an interaction But they do not always include levels of uncertainty as a control! [Note: whenever estimating interactions you must always always include the levels of all variables as well, otherwise mis-specified!]

14. Nick Bloom, Macro Topics, Spring 2009 14 They find a “cautionary effect” of uncertainty This is obviously too small…. I put this up to show you the QJE table format – full notes at bottom of the table. Always do this in your papers (including in drafts)

15. Nick Bloom, Macro Topics, Spring 2009 15 They find a “cautionary effect” of uncertainty

16. Nick Bloom, Macro Topics, Spring 2009 16 Other parts of the paper The paper also has other tests of the real-options, finding for σ: More impact for irreversible capital (directly measured and indirectly measured using Shleifer and Vishny (1992)) More impact at higher market power Occurs in structures, machinery & vehicle investment Look reasonable and good to push the empirics with these additional tests – although small sample size (500 obs) so tenuous My guess is these were – appropriately – requested during the refereeing process

17. Nick Bloom, Macro Topics, Spring 2009 17 Message is uncertainty reduces responsiveness Good paper – how could you build on this: Theory – take a more structural approach. Again no real link between theory and empirics Identification – cross-sectional data without any IV “So what” factor – push some interesting implication if uncertainty varies by time, region, industry etc..

18. Nick Bloom, Macro Topics, Spring 2009 18 Nick Bloom, Steve Bond & John Van Reenen (2007) “Uncertainty and Investment Dynamics” Review of Economic Studies

19. Nick Bloom, Macro Topics, Spring 2009 19 Overview Paper also estimates the effect of uncertainty on investment… Contribution is goes directly from theory to empirics to derive robust predictions and test these Shows higher uncertainty generates a large and robust “caution effect”: 1 SD increase in σ ½’s investment response Shows this is robust to aggregation (cross-section & time) Takes a matched theory-empirics approach (panel, GMM) Also has a range of tests of impacts of different types of adjustment costs, uncertainty effects and functional forms

20. Nick Bloom, Macro Topics, Spring 2009 20 The rewards of impressive modelling

21. Nick Bloom, Macro Topics, Spring 2009 21 Cites pretty good for its age, and a lesson on not changing paper titles

22. Nick Bloom, Macro Topics, Spring 2009 22 Basic setup The paper is split between theory and empirics Theory is simulation based (this is possible, but put code on-line): Solves for time varying σ Shows σ induces “caution” – like an adjustment cost Shows this is robust to aggregation – empirically important Shows on simulated data this effect can be estimated (by GMM) Shows on actual data find similar results (by GMM) Show robust to various tests (correctly requested by referees)

23. Nick Bloom, Macro Topics, Spring 2009 23 The “cautionary effect” of uncertainty

24. Nick Bloom, Macro Topics, Spring 2009 24 Estimated by GMM on simulated data

25. Nick Bloom, Macro Topics, Spring 2009 25 Estimated by GMM on actual data

26. Nick Bloom, Macro Topics, Spring 2009 26 Use empirical results to show variations in σ matter

27. Nick Bloom, Macro Topics, Spring 2009 27 Message is theory and empirics show uncertainty reduces responsiveness How could you build on this: Identification – everything moves together so not clear what is identifying what (GMM is no magic bullet). Find some exogeneous shift in σ which does not effects levels? Data – better measures of uncertainty, for example use implied volatility (forward looking) or a direct measure. Also could use higher frequency data (quarterly Compustat data) Other outcomes – look at labor, R&D, productivity etc…

28. Nick Bloom, Macro Topics, Spring 2009 28 I think this is an interesting research area as uncertainty also looks like it is counter-cyclical Shaded areas are recessions