Investment Under Uncertainty and Economic Growth: A Quantitative Investigation

Recent empirical economic growth literature has made significant progress in quantifying the role of a variety of factors driving cross-country differences in long-run output levels and in characterizing the process of convergence of countries' output growth rates toward their steady-state values. However, relatively little is yet known about the quantitative role of households' and firms' uncertainty regarding their future economic environments in long-run economic development. This is so even though such uncertainty has been increasingly recognized in the consumption and investment literatures to be a key determinant for households' saving decisions as well as for firms' investment decisions. This paper aims to explore, for both time-series and cross-section dimensions, the role of uncertainty in economic growth within the context of an optimal growth model with firms' investment decisions modelled explicitly and investment being at least partially irreversible and returns uncertain. Using this framework, the paper studies (i) the fraction of cross-country differences in long-run capital-output ratios due to firms' uncertainty about the rates of return on their investment, and (ii) whether transitional dynamics in a stochastic optimal-growth model with rate-of-return uncertainty are prolonged enough to explain sustained cross-country differences in output growth rates. The paper also considers the ability of economic policy to foster economic growth and welfare through provision of stable environments for saving and capital-investment decisions.