Investment under Uncertainty and Financial Market Development: A q-Theory Approach

Sergio Lehmann

Working Papers Central Bank of Chile from Central Bank of Chile

Abstract: The paper presents a theoretical model of investment under uncertainty, incorporating the financial sector development as a key factor for determining the effect and level of uncertainty. As a difference with previous works, the model is developed using a Tobin's q approach, analyzing the effects from an equilibrium perspective -comparative static-. The model assumes partial reversibility in investment decisions and a representative firm participating in a non-competitive market. Uncertainty is associated to the market conditions faced by the firm in the commercialization of the products or services that offers. From the model we conclude that uncertainty affects negatively the capital accumulation process. Assuming an initial equilibrium condition, as uncertainty increases, a higher expected growth on market conditions will be required in order to remain in an equilibrium state. If the requirement is not satisfied, as should occur in the short run, q decreases and, as a consequence, the stock of capital. The dynamic on q makes the firm gradually converge to a pseudo equilibrium point, where it stays while there is no change in uncertainty about market conditions, increase in the expected growth of market conditions is not verified or the financial market does not become more developed. Financial market deepness has important effects on economic agents ability to diversify risk, accuracy in firms' valuation and economic volatility. Then, a more developed financial market conducts the economy to an improved environment; less uncertainty is perceived by investors and its effect over decision making is reduced. As a result, investment increases, strengthening the economic growth capacity.

Date: 1997-10
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Persistent link: https://EconPapers.repec.org/RePEc:chb:bcchwp:17

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