The Impact of Exchange Rate Uncertainty on the Level of Investment

CEPR Discussion Paper Series No. 1896

Posted: 23 Dec 1998

See all articles by Julia Darby

Julia Darby

University of Strathclyde, Glasgow - Strathclyde Business School - Department of Economics

Andrew J. Hughes

Cardiff Business School; Centre for Economic Policy Research (CEPR); Vanderbilt University - College of Arts and Science - Department of Economics

Jonathon Ireland

University of Strathclyde

Laura Piscitelli

Bank of England - Monetary Analysis Division

Date Written: May 1998

Abstract

Conventional wisdom has it that increasing price or exchange rate uncertainty will depress investment. Using the Dixit-Pindyck model, we find that there are situations where this does happen and situations where it does not, i.e., increasing uncertainty leads to more investment. It depends first on the risk of being stuck with (ex-post) unwanted investments, then on the ratio of that risk to the opportunity cost of waiting, and finally on the initial level of uncertainty. There are important threshold effects as you switch from one determinant to another. That allows us to identify when rising volatility would increase or decrease investment and also to identify which types of industries would gain, and which would suffer, from a move to fixed exchange rates. This is important for monetary union in Europe since it is likely that, even if trade is insensitive to exchange rate volatility, investment with its longer horizon (beyond insurance on the futures markets) is sensitive to such volatility. Our empirical results confirm that.

JEL Classification: E22, F21

Suggested Citation

Darby, Julia and Hughes Hallett, Andrew J. and Ireland, Jonathon and Piscitelli, Laura, The Impact of Exchange Rate Uncertainty on the Level of Investment (May 1998). CEPR Discussion Paper Series No. 1896, Available at SSRN: https://ssrn.com/abstract=126729

Julia Darby (Contact Author)

University of Strathclyde, Glasgow - Strathclyde Business School - Department of Economics ( email )

Sir William Duncan Building
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HOME PAGE: http://www.economics.strath.ac.uk/julia/

Andrew J. Hughes Hallett

Cardiff Business School ( email )

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Centre for Economic Policy Research (CEPR)

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Vanderbilt University - College of Arts and Science - Department of Economics ( email )

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Jonathon Ireland

University of Strathclyde ( email )

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Laura Piscitelli

Bank of England - Monetary Analysis Division ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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