It is obvious to any business person that economic decisions often depend critically on the nature and extent of market risk. Clearly a decision to invest in new capital will depend not only on projections of market demand, but also on the degree to which future demand is uncertain. Indeed, much of corporate finance theory, as taught in business schools, deals with methods for properly taking risk into account when making capital budgeting decisions. Yet most econometric models of aggregate economic activity ignore the role of risk, or deal with it only implicitly. The point of this paper is that a more explicit treatment of risk may help to better explain and forecast economic fluctuations, and especially movements in investment spending.
Consider, for example, the recessions of 1975 and 1980. The sharp jumps in world energy prices that occured in 1974 and 1979-80 clearly contributed to those recessions, and they did so in a number of ways. First, they caused a reduction in the real national incomes of oil importing countries. Second, they led to "adjustment effects" -- inflation and a further drop in real income and output resulting from the rigidities that prevented wages and non-energy prices from coming into equilibrium quickly.
But those energy shocks also caused greater uncertainty over future economic conditions. For example, it was unclear whether energy prices would continue to rise or later fall, what the impact of higher energy prices would be on the marginal product of various types of capital, how long-lived the inflationary impact of those shocks would be, etc. Other events also contributed to what became a more uncertain economic environment, especially in 1979-82: much more volatile exchange rates, and (at least in the U.S.) more volatile interest rates. This increased uncertainty must have contributed to the decline in investment spending that occured during these periods.
This more volatile economic environment was reflected in an increase in the volatility of U.S. stock prices. From 1970 to 1981, the average monthly variance of the New York Stock Exchange Index was about 2.5 times as large as for the period 1950-1969. This increase in stock market volatility can be explained in part by the more volatile economic conditions described above. Elsewhere I have argued that it corresponds to an increase in the variance of the real gross marginal return on capital. Again, this should have affected investment spending, and economic performance in general.
In what follows I will focus on investment spending, and argue that a more explicit treatment of risk is needed to better model and forecast investment at the aggregate or sectoral level. This is particularly true when investment is irreversible, as most investment is, at least in part. In such a case the decision to invest involves an additional opportunity cost -- installing capital today forecloses the possibility of installing it instead at some point in the future (or never installing it at all). Put differently, a firm has options to install capital at various points in the future (options that can be exercised at the cost of purchasing the capital), and if the firm installs capital now, it closes those options. If uncertainty over future market conditions increases, the opportunity cost associated with closing these options increases, and current investment spending becomes less attractive.
In the next two sections I explain this aspect of firms' investment decisions in more detail, and discuss the implications for q-theory models of investment. Section 4 presents the results of some simple (and preliminary) empirical tests. These results indicate that risk does seem to help explain and predict aggregate investment spending.
