Irreversibility and Aggregate Investment, Issue 3865
National Bureau of Economic Research, 1991 - Investments - 28 pages
Investment is often irreversible, in that installed capital has little or no value unless used in production. In the presence of ongoing uncertainty, an individual firm's irreversible investment policy optimally alternates short bursts of positive gross investment to periods of inaction, when the installed capital stock is allowed to depreciate. The behavior of aggregate investment series is characterized by sluggish, continuous adjustment instead. We argue in this paper that aggregate dynamics should be interpreted in terms of unsynchronized irreversible investment decisions by heterogenous firms, rather than in terms of ad-hoc adjustment cost functions in a representative-agent framework. We propose a closed-form solution for a realistic model of sequential irreversible investment, characterize the aggregate implications of microeconomic irreversibility and idiosyncratic uncertainty, and interpret U.S. data in light of the theoretical results.
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actual investment adjustment costs aggregate developments aggregate investment aggregate shocks aggregate uncertainty Appendix approximation Bertola and Caballero boundary conditions Brownian motion Bureau of Economic Caballero 1990 Caballero and Engel characterized Cobb-Douglas coefficient cointegrating constant elasticity cost of capital cross sectional distribution cross-sectional distribution define denote depreciate derived desired capital stock dG(t empirical distribution estimation exogenous factors of production firm functional equations functional forms Giuseppe Bertola idiosyncratic sources idiosyncratic uncertainty implied individual units initial condition installed capital stock investment irreversibility investment policy investment rate investment series investment/capital ratio irreversibility constraint Ito's lemma kd(t kf(t leads and lags marginal revenue product microeconomic NBER neoclassical nonstochastic observed obtain optimal irreversible investment parameters price of capital probability distribution product of capital realistic regressors relevant sample path serial correlation solution sources of uncertainty standard deviation stock of capital unit-level unit's user cost variable variance-covariance matrix volatility Wiener process yields zero