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Investment Irreversibility and Precautionary Savings in General Equilibrium

João Ejarque
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João Ejarque: Institute of Economics, University of Copenhagen

No 96-24, Discussion Papers from University of Copenhagen. Department of Economics

Abstract: Partial equilibrium models suggest that when uncertainty increases, agents increase savings and at the same time reduce investment in irreversible goods. This paper characterizes this problem in general equilibrium with technology shocks, additive output shocks and shocks to the marginal efficiency of investment. Uncertainty is associated with the variance of these random variables, and irreversibility is introduced by a non negativity constraint on investment. I find that irreversibility and changes in uncertainty can be responsible for sizeable movements in aggregate consumption and investment only if the shocks affect the marginal efficiency of investment. For all types of shocks, when concavity of the utility function is moderate or high, the irreversibility constraint never binds and the increase in variance has a negligible impact. Persistence in the shock process induces precautionary savings rather than irreversibility effects. If shocks are idiosyncratic and affect a cross section of agents over capital, an increase in their variance may induce an increase in aggregate investment even if all agents have an incentive to invest less, because zero investment is now an active lower bound for part of the cross section distribution.

Pages: 27 pages
Date: 1996-12
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