Academic journal article Journal of Money, Credit & Banking

Inflation Uncertainty, Relative Price Uncertainty, and Investment in U.S. Manufacturing

Academic journal article Journal of Money, Credit & Banking

Inflation Uncertainty, Relative Price Uncertainty, and Investment in U.S. Manufacturing

Article excerpt

CHANGES IN UNCERTAINTY ABOUT THE FUTURE INFLATION rate can be expected to have numerous effects on an economy. Increased inflation uncertainty means larger realizations of unexpected inflation, so any costs associated with unexpected inflation are naturally associated with an increase in inflation uncertainty. Inflation uncertainty might be incorporated into interest rates, and thereby affect the intertemporal allocation decisions made in an economy.(1) In a world of nominal rigidities, inflation uncertainty could affect intratemporal allocation decisions through its effect on uncertainty about the real cost of various factors of production and its effect on uncertainty about the relative price of various final goods. Lucas (1973) argues that in world without nominal rigidities but with imperfect information, the sensitivity of economic agents' actions to price signals can be dependent on the amount of inflation uncertainty.

This paper empirically investigates whether inflation uncertainty significantly affects the allocation of resources in U.S. manufacturing. It does so by focussing on one specific potential connection between inflation uncertainty and resource allocation--a link between inflation uncertainty and investment. The transmission mechanism for the possible link is uncertainty about the real net present value of capital expenditures. It is argued that one might expect both a connection between inflation uncertainty and uncertainty about the real net revenues that investment projects produce and a connection between uncertainty about these revenues and investment.

Concentrating attention on this transmission mechanism reflects an interest in determining whether recent developments in the economic theory of investment capture empirically important behavior. These developments, nicely summarized by Pindyck (1991) and Cabellero (1991), emphasize that option pricing theory can have significant implications for firms considering whether to undertake a costly, irreversible capital expenditure. As discussed in more detail in the following section, in some circumstances a firm gives up an option when it decides to make a capital expenditure. Higher uncertainty about the real net revenues that the capital expenditure generates makes this option more valuable and makes the firm more reluctant to proceed with the capital outlay.

The outline for this paper is as follows. The next section contains a discussion of an example that shows how uncertainty about the real net present value of an investment project can influence whether that project is undertaken. While not new, the example is included in order to emphasize that this influence can be quite large and economically meaningful. The potential connections between inflation uncertainty and uncertainty about the real net present value of capital expenditures are also discussed. It is argued that, for the case of U.S. manufacturing, connections can be through uncertainty about real wages, uncertainty about the real price of output, and/or uncertainty about the profit rate.

The empirical analysis in this paper, involving examination of both time-series and cross-sectional evidence, appears in sections 2 and 3. Section 2 provides the time-series evidence, using aggregate quarterly data. The behavior of U.S. inflation is examined to determind if there is significant variation over time in inflation uncertainty. A similar examination of the behavior of the real wage, real output price, and profit rate in U.S. manufacturing is also performed. Detectable time series variation in inflation uncertainty is then related to detectable time series variation in these other types of uncertainty. Finally, the correlation between movements over time in capital expenditures in U.S. manufacturing and movements over time in uncertainty about the real wage, the real output price, the profit rate, and inflation is investigated.

Section 3 provides the cross-sectional evidence. …

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