DP1896 | The Impact of Exchange Rate Uncertainty on the Level of Investment

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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.