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The Finance-Uncertainty Multiplier

Xiaoji Lin (), Nicholas Bloom () and Ivan Alfaro
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Ivan Alfaro: The Ohio State University

No 887, 2017 Meeting Papers from Society for Economic Dynamics

Abstract: We show theoretically and empirically how real and financial frictions amplify the impact of uncertainty shocks on firms' investment, employment, debt (term structure of debt growth), and cash holding. We start by building a model with real and financial frictions, alongside uncertainty shocks, and show how adding financial frictions to the model roughly doubles the negative impact of uncertainty shocks on investment and hiring. The reason is higher uncertainty induces the standard negative real-options effects on the demand for capital and labor, but also leads firms to hoard cash and cut debt to hedge against future shocks, further reducing investment and hiring. We then test the model using a panel of US firms and a novel instrumentation strategy for uncertainty exploiting differential firm exposure to exchange rate and factor price volatility. We find that higher uncertainty reduces real investment and hiring, while also leading firms to increase cash holdings by cutting debt, dividends and stock-buy backs, and these effects are strongest in periods of higher financial frictions and for the most financially constrained firms. This highlights why in periods with greater financial frictions -- like during the global-financial-crisis -- uncertainty can be particularly damaging.

New Economics Papers: this item is included in nep-dge and nep-pke
Date: 2017
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Working Paper: The Finance Uncertainty Multiplier (2018) Downloads
Working Paper: The Finance Uncertainty Multiplier (2017) Downloads
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