Investment Irreversibility in a Granular World

Tatsuro Senga and Iacopo Varotto
Additional contact information
Tatsuro Senga: KEIO UNIVERSITY AND QUEEN MARY UNIVERSITY OF LONDON
Iacopo Varotto: BANCO DE ESPAÑA

No 2546, Working Papers from Banco de España

Abstract: Does micro-level investment irreversibility amplify or dampen business cycles? We show this depends on the source of aggregate risk. Investment irreversibility reduces fluctuations in both aggregate output and investment when firm-level idiosyncratic shocks aggregate up to economy-wide effects. This contrasts with models driven by aggregate productivity shocks, where irreversibility has little effect on volatility. The key is whether idiosyncratic shocks are suffi ciently volatile to cause the irreversibility constraint to bind cyclically for a significant mass of firms. If so, investment irreversibility hampers productivity-enhancing capital reallocation and reduces business cycle volatility. Moreover, household consumption smoothing is impeded when firms cannot adjust capital optimally, increasing real wage volatility. This labor market effect, combined with capital misallocation, reduces aggregate output volatility by 22 percent and investment volatility by 60 percent. These results highlight the importance of considering the source of economic volatility when assessing investment frictions. We provide empirical support for these predictions using firm-level investment data from Compustat.

Keywords: investment irreversibility; business cycles; idiosyncratic shocks; capital misallocation (search for similar items in EconPapers)
JEL-codes: D25 E22 E23 E32 (search for similar items in EconPapers)
Pages: 67 pages
Date: 2025-11
New Economics Papers: this item is included in nep-dge
References: Add references at CitEc
Citations:

Downloads: (external link)
https://www.bde.es/f/webbe/SES/Secciones/Publicaci ... 25/Files/dt2546e.pdf First version, November 2025 (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:bde:wpaper:2546

DOI: 10.53479/41857

Access Statistics for this paper

More papers in Working Papers from Banco de España Contact information at EDIRC.
Bibliographic data for series maintained by Ángel Rodríguez. Electronic Dissemination of Information Unit. Research Department. Banco de España ().