nep-mac New Economics Papers
on Macroeconomics
Issue of 2006‒09‒03
25 papers chosen by
Soumitra K Mallick
Indian Institute of Social Welfare and Bussiness Management

  1. Modern Macroeconomics in Practice: How Theory is Shaping Policy By Patrick Kehoe; Varadarajan V. Chari
  2. Optimal Monetary Policy with Collateralized Household Debt and Borrowing Constraints By Tommaso Monacelli
  3. Imperfect Transparency and Shifts in the Central Bank's Output Gap Target By Niklas J. Westelius
  4. A Theory of Demand Shocks By Guido Lorenzoni
  5. Which inflation to target? A small open economy with sticky wages indexed to past inflation. By A. Campolmi
  6. Inflation Band Targeting and Optimal Inflation Contracts By Niklas J. Westelius; Frederic S. Mishkin
  7. International Evidence on the Efficacy of new-Keynesian Models of Inflation Persistence By Oleg Korenok; Stanislav Radchenko; Norman R. Swanson
  8. Quantifying the impact of structural reforms By Ekkehard Ernst; Gang Gong; Willi Semmler; Lina Bukeviciute
  9. Declining valuations and equilibrium bidding in central bank refinancing operations. By Christian Ewerhart; Nuno Cassola; Natacha Valla
  11. Macroeconomic implications of demographic developments in the euro area By Angela Maddaloni; Alberto Musso; Philipp Rother; Melanie Ward-Warmedinger; Thomas Westermann
  12. Public Investment, Economic Performance and Budgetary Consolidation: VAR Evidence for the 12 Euro Countries By Alfredo M. Pereira; Maria de Fátima Pinho
  13. International Exchange Rate Systems - Where do we Stand? By Horst Siebert
  14. On the Usefulness of the Constrained Planning Problem in a Model of Money By Bhattacharya, Joydeep; Singh, Rajesh
  15. Exchange market pressure and the credibility of Macau's currency Board By Macedo, Jorge Braga de; Braz, José; Pereira, Luis brites; Nunes, Luis C.
  16. The euro as invoicing currency in international trade. By Annette Kamps
  17. Recent macroeconomic performance in colombia: what went wrong? By ARANGO, Luis Eduardo; IREGUI, Ana María; MELO, Luis F.
  18. The importance of being mature - the effect of demographic maturation on global per-capita GDP By Rafael Gómez; Pablo Hernández de Cos
  19. The Equity Premium Implied by Production By Urban Jermann
  20. Macroeconometric modelling for evaluationg the policy impact on growth in dualistic countries: the case of Southern Italian Regions By Stefania P. S. Rossi; Guido Pellegrini; Ornella Tarola
  21. Financial Intermediation, Moral Hazard, And Pareto Inferior Trade By Hansen, Bodil Olai; Keiding, Hans
  22. Globalization and Risk Sharing By Jaume Ventura; Fernando A. Broner
  23. Trust and Economic Growth: A Panel Analysis By Roth, Felix; Schüler, Dana
  24. Social Security and Intergenerational Redistribution By Bhattacharya, Joydeep; Reed, Robert
  25. Irreversible Investment, Real Options, and Competition: Evidence from Real Estate Development By Laarni Bulan; Christopher J. Mayer; C. Tsuriel Somerville

  1. By: Patrick Kehoe; Varadarajan V. Chari
    Abstract: Theoretical advances in macroeconomics made in the last three decades have had a major influence on macroeconomic policy analysis. Moreover, over the last several decades, the United States and other countries have undertaken a variety of policy changes that are precisely what macroeconomic theory of the last 30 years suggests. The three key developments that have shaped macroeconomic policy analysis are the Lucas critique of policy evaluation due to Robert Lucas, the time inconsistency critique of discre-tionary policy due to Finn Kydland and Edward Prescott, and the development of quantitative dynamic stochastic general equilibrium models following Finn Kydland and Edward Prescott.
    JEL: E21 E4 E43 E5 E52 E58 E6 E62 E65 H2 H25 H3
    Date: 2006–08
  2. By: Tommaso Monacelli
    Abstract: We study optimal monetary policy in an economy with nominal private debt, borrowing constraints and price rigidity. Private debt reflects equilibrium trade between an impatient borrower, who faces an endogenous collateral constraint, and a patient saver, who engages in consumption smoothing. Since inflation can positively affect borrower's net worth, monetary policy optimally balances the incentive to offset the price stickiness distortion with the one of marginally relaxing the borrower's collateral constraint. We find that the optimal volatility of inflation is increasing in three key parameters: (i) the borrower's weight in the planner's objective function; (ii) the borrower's impatience rate; (iii) the degree of price flexibility. In general, however, deviations from price stability are small for a small degree of price stickiness. In a two-sector version of our model, in which durable price movements can directly affect the ability of borrowing, the optimal volatility of (non-durable) inflation is more sizeable. In our context, and relative to simple Taylor rules, the Ramsey-optimal allocation entails a partial smoothing of real durable goods prices.
    JEL: E24 E44 E5
    Date: 2006–08
  3. By: Niklas J. Westelius (Hunter College)
    Abstract: Despite a drastic increase in transparency in recent years, most central banks remain reluctant to reveal their future intended course of policy. This paper analyzes the case where the central bank’s output gap target is private information. It is assumed that the target is subject to temporary and persistent shocks motivated either by measurement errors of potential output or as a result of political pressure. Under imperfect transparency the public cannot observe the true degree of persistence of the shock to the target and must learn by observing past data. In this setting, the paper shows that the welfare implications of imperfect transparency critically depend on whether monetary policy is characterized by discretion or commitment. Indeed, under discretion imperfect transparency decreases inflation and output gap variability and thus increases welfare. Under commitment, the effect on inflation and output variability is ambiguous and depends on the degree of persistence of the shifts in the output target. Welfare, however, is shown to unambiguously decline under imperfect transparency and commitment.
    Keywords: Transparency, Monetary Policy, Discretion, Commitment
    JEL: E5 E52 E61
    Date: 2006
  4. By: Guido Lorenzoni
    Abstract: This paper presents a model of business cycles driven by shocks to consumer expectations regarding aggregate productivity. Agents are hit by heterogeneous productivity shocks, they observe their own productivity and a noisy public signal regarding aggregate productivity. The shock to this public signal, or "news shock," has the features of an aggregate demand shock: it increases output, employment and inflation in the short run and has no effects in the long run. The dynamics of the economy following an aggregate productivity shock are also affected by the presence of imperfect information: after a productivity shock output adjusts gradually to its higher long-run level, and there is a temporary negative effect on inflation and employment. A calibrated version of the model is able to generate realistic amounts of short-run volatility due to demand shocks, in line with existing time-series evidence. The paper also develops a simple method to solve forward-looking models with dispersed information.
    JEL: D58 D84 E32 E40
    Date: 2006–08
  5. By: A. Campolmi
    Date: 2005
  6. By: Niklas J. Westelius (Hunter College); Frederic S. Mishkin (Graduate School of Business Columbia University)
    Abstract: In this paper we examine how target ranges work in the context of a Barro-Gordon (1983) type model, in which the time-inconsistency problem stems from political pressures from the government. We show that target ranges turn out to be an excellent way to cope with the time-inconsistency problem, and achieve many of the benefits that arise under practically less attractive solutions such as the conservative central banker and optimal inflation contracts. Our theoretical model also shows how an inflation targeting range should be set and how it should respond to changes in the nature of shocks to the economy
    Keywords: Inflation Band Targeting, Inflation Contract, Time-inconsistent policy
    JEL: E52 E58
    Date: 2006
  7. By: Oleg Korenok (Department of Economics, VCU School of Business); Stanislav Radchenko (Department of Economics, University of North Carolina at Charlotte); Norman R. Swanson (Department of Economics, Rutgers University)
    Abstract: In this paper we take an agnostic view of the Phillips curve debate, and carry out an empirical investigation of the relative and absolute efficacy of Calvo sticky price (SP), sticky information (SI), and sticky price with indexation models (SPI), with emphasis on their ability to mimic inflationary dynamics. In particular, we look at evidence for a group of 13 OECD countries, and we consider three alternative measures of inflationary pressure, including the output gap, labor share, and unemployment. We find that the Calvo SP and the SI models essentially perform no better than a strawman constant inflation model, when used to explain inflation persistence. Indeed, virtually all inflationary dynamics end up being captured by the residuals of the estimated versions of these models. We find that SPI model is preferable because it captures the type of strong inflationary persistence that has in the past characterized the economies of the countries in our sample. However, two caveats to this conclusion are that improvement in performance is driven mostly by the time series part of the model (i.e. lagged inflation) and that the SPI model overemphasizes inflationary persistence. Thus, there appears to be room for improvement via either modified versions of the above models, or via development of new models, that better "track" inflation persistence.
    Keywords: sticky price, sticky information, empirical distribution, model selection
    JEL: E12 E3 C32
    Date: 2006–06
  8. By: Ekkehard Ernst (Corresponding author: OECD, Economics Department, 2, Rue André Pascal, 75775 Paris Cedex 16, France.); Gang Gong (School of Economics and Management, Tsinghua University, Beijing 100084, China.); Willi Semmler (New School and SCEPA, New York, and CEM, Bielefeld University. Contacts: The New School for Social Research, 65 Fifth Avenue, New York, NY 10003, USA.); Lina Bukeviciute (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: We estimate a dynamic intertemporal model with non-clearing markets that mimics features of European labour markets, such as sticky nominal wages and sluggish adjustment of employment to shocks for 15 OECD countries. The estimates include a measure for the degree of labour market sluggishness that compares well with standard indicators of product and labour market regulation. Calibration of the model on a selected country sample confirms its explanatory power in comparison with the standard competitive markets model. In a second step, the measure for labour market sluggishness is used as a policy variable and model variants are simulated in order to assess the extent to which the countries would have performed better with more flexible labour markets. These policy experiments show that an increase in labour market flexibility reduces the volatility of consumption relative to production, improves intertemporal efficiency but entails higher employment risk for households. JEL Classification: E32, C61.
    Keywords: Nominal and real rigidities, non-clearing labour markets, business cycles, labour market reforms in OECD countries.
    Date: 2006–08
  9. By: Christian Ewerhart (Institute for Empirical Research in Economics (IEW), Winterthurerstrasse 30, CH-8006 Zurich, Switzerland.); Nuno Cassola (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Natacha Valla (Banque de France, 39, rue Croix-des-Petits-Champs, F-75049 Paris Cedex 01, France.)
    Abstract: It is argued that bidders in liquidity-providing central bank operations should typically possess declining marginal valuations. Based on this hypothesis, we construct an equilibrium in central bank refinancing operations organised as variable rate tenders. In the case of the discriminatory pricing rule, bid shading does not disappear in large populations. The predictions of the model are shown to be consistent with the data for the euro area. JEL Classification: D44, E52.
    Keywords: Open market operations, uniform price auction, discriminatory auction, Eurosystem.
    Date: 2006–08
  10. By: Viv B. Hall; C. John McDermott
    Abstract: The current economic expansion is one of the more enduring in New Zealand's post-war period. But is this a change from past behaviour? We examine New Zealand's post-war business cycles for the sample period 1946q1 to 2005q4, using a newly developed 60-year quarterly time series for real GDP. The non-parametric Bry and Boschan (1971) algorithm is used to derive Classical business cycle turning points, and to underpin the establishment of key cycle characteristics. The latter include cycle asymmetries, volatility, diversity and degree of duration dependence. Markov-switching models estimated by Gibbs-sampling methods (Kim and Nelson, 1999), are then used to derive mean growth rate and volatility regimes, and to draw implications. Results point to a return to a more rhythmic pattern of long expansions and short contractions, after that pattern was interrupted following the oil shocks of the 1970s and New Zealand's reforms of the mid to late 1980s and early 1990s. More rhythmic patterns should not be mistaken for a predetermined pattern, as duration test results show that cycle expansion paths do not age. This, together with the onservation that rates of growth are not dissimilar across the more sustained expansion phases, implies that in order to enhance New Zealand's prospoerity, policies are required that extend business cycle expansions without allowing the excesses that undermine those expansions to build up.
    JEL: E23 E32
    Date: 2006–08
  11. By: Angela Maddaloni (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Alberto Musso (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Philipp Rother (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Melanie Ward-Warmedinger (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Thomas Westermann (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper examines the macroeconomic consequences of future demographic trends for economic growth, financial markets and public finances. It shows that in the absence of reforms and responses by economic agents, the currently projected demographic trends imply a decline in average real GDP growth and a severe burden in terms of pay-as-you-go pension and health care systems. Population ageing will change the financial landscape, with a potentially larger role for financial intermediaries and asset prices. All this points to a need to closely monitor demographic change also from a monetary policy perspective. While population projections are surrounded by considerable uncertainty and the effects of demographic change tend to be drawn out, the magnitude of the potential effects calls for an early recognition of this issue. This paper provides some input to the examination of possible policy issues.
    Date: 2006–08
  12. By: Alfredo M. Pereira (Department of Economics, College of William and Mary); Maria de Fátima Pinho (Instituto Superior de Contabilidade e Administração)
    Abstract: In a period of heightened concern about fiscal consolidation in the euro area a politically expedient way of controlling the public budget is to cut public investment. A critical question, however, is whether or not political expediency comes at a cost, in terms of both long-term economic performance and future budgetary contention efforts. First, common wisdom suggests that public investments have positive effects on economic performance although the empirical evidence is less clear. Second, it is conceivable that public investment has such strong effects on output, that over time it generates enough additional tax revenues to pay for itself. Obviously, it is equally plausible that the effects on output although positive are not strong enough for the public investment to pay for itself. In this paper we investigate these issues empirically for the twelve countries in the euro area using a vector auto-regressive approach. We conclude that the euro countries can be gathered in four groups according to the nature of the economic and budgetary impact of public investment. The first group includes Austria, Belgium, Luxembourg, and Netherlands, where the economic effects are either negative or positive but very small and, therefore, cuts will be harmless for the economy and effective from a budgetary perspective. The second group includes Finland, Portugal, and Spain, where public investment does not pay for itself and, therefore, cuts are an effective tool of budgetary consolidation although they are harmful for the economy. The third group includes France, Greece, and Ireland where public investment just pays for itself and therefore cuts are not an effective way of achieving long-term budgetary consolidation and are harmful for the economy. Finally, the fourth group includes Germany and Italy, where public investment more than pays for itself and, therefore, cuts are not only harmful for the economy but also counterproductive from a budgetary perspective.
    Keywords: public investment, economic performance, budgetary consolidation, euro area
    JEL: C32 E62 H54
    Date: 2006–08–23
  13. By: Horst Siebert
    Abstract: This paper analyzes institutional arrangements for exchange rate systems and reviews what we know. It looks at the foreign exchange market, different balance of payment situations in which countries find themselves and the necessary exchange rate adjustments. It studies the options that are available to countries in choosing their exchange rate system (type of nominal anchor, nominal anchor versus real target and the degree of sovereignty to be given up) and reviews the historical experience for multilateral options. The actual system is a fragile low-inflation central bank dominated arrangement. Options for the future rest on quite a few idealistic ideas. In addition to choosing the exchange rate system, adopting the right exchange rate is also addressed.
    Keywords: Exchange rate systems, Balance of payments situations, External and internal equilibrium, Choosing the exchange rate system, Unilateral and multilateral arrangements, Options for the future, Universal money
    JEL: E E5 E42 E58 E61 F31 F32 F33
    Date: 2006–08
  14. By: Bhattacharya, Joydeep; Singh, Rajesh
    Abstract: In this paper, we study a decentralized monetary economy with a specified set of markets, rules of trade, an equilibrium concept, and a restricted set of policies and derive a set of equilibrium (monetary) allocations. Next we set up a simpler constrained planning problem in which we restrict the planner to choose from a set that contains the set of equilibrium allocations in the decentralized economy. If there is a government policy that allows the decentralized economy to achieve the constrained planner's allocation, then it is the optimal policy choice. To illustrate the power of such analyses, we solve such planning problems in three monetary environments with limited communication. The upshot is that solving constrained planning problems is an extremely "efficient" (easy and quick) way of deriving optimal policies for the corresponding decentralized economies.
    Keywords: planning problems, overlapping generations, random relocation model
    JEL: E4
    Date: 2006–08–23
  15. By: Macedo, Jorge Braga de; Braz, José; Pereira, Luis brites; Nunes, Luis C.
    Abstract: In this study, we assess the credibility of the currency board arrangement (CBA) of the Macau Special Administrative Region by studying the relationship between exchange market pressure (EMP) and the anchors of a rule-based CBA, namely, interest rate arbitrage, exchange rate arbitrage and economic discipline. A pure CBA signals its credibility by allowing the first two anchors to function automatically and by pursuing sound fiscal policies. The analysis’ results suggest that Macau’s CBA has been characterised by a state of low volatility since late 1992, with the brief exception of the East Asian financial crisis period. The paper’s main finding is that fiscal fundamentals seem to have a more pronounced role in reducing EMP’s variability during periods of low volatility whilst interest rate arbitrage is more important in periods of high volatility. We conclude that Macau’s CBA is credible at present as reflected in the low frequency of observed EMP, in the narrowing of Macau’s interest rate differential vis-à-vis U.S. interest rates and in Macau’s substantial fiscal reserves.
    Date: 2006
  16. By: Annette Kamps (Kiel Institute for the World Economy, Düsternbrooker Weg 120, 24105 Kiel, Germany.)
    Abstract: This paper investigates the determinants of currency invoicing in international trade. Although the currency of invoicing is central for the transmission of monetary policy, empirical research on this topic is scarce due to a lack of data. With a new extensive invoicing dataset and a panel model analysis this paper shows that a country’s membership or prospective membership of the EU plays a decisive role in the choice of the euro as invoicing currency. The role of the euro as vehicle currency is increasing but still limited when compared to the U.S. dollar. Monetary instability and low product differentiation favour vehicle pricing in U.S. dollar. An increase of euro invoicing due to higher exchange rate volatility supports the role of the euro as vehicle currency, however. High market power defined as the share of a country’s total exports to world exports and membership of the euro area make invoicing in the home currency (euro) more likely. JEL Classification: F41, F42, L11.
    Keywords: International trade, currency invoicing, panel data.
    Date: 2006–08
  17. By: ARANGO, Luis Eduardo; IREGUI, Ana María; MELO, Luis F.
    Abstract: Al finalizar la década anterior la actividad real en Colombia experimentó la más aguda recesión de los últimos 50 años. Para explicar este fenómeno, postulamos un modelo VAR estructural no-triangular que describe la dinámica de la producción, los precios, el desempleo y los salarios durante las últimas dos décadas. La evidencia sugiere que, en el largo plazo, la política monetaria ha sido neutral con respecto al producto y la desempleo, mientras que la principal razón para el incremento de éste último se explica por la forma en que se han determinado los salarios (formación de expectativas hacia atrás) y el incremento de los costos no salariales.
    Date: 2006–01–01
  18. By: Rafael Gómez (London School of Economics and Banco de España Visiting Research Fellow; Address: London School of Economics & Political Science - Interdisciplinary Institute of Management, Houghton Street, London WC2A 2AE, United Kingdom.); Pablo Hernández de Cos (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: Given that savings behaviour and worker productivity have strong life-cycle components and given that demographic profiles vary across countries, population age structure should be linked to differences in levels of economic development. In this paper we measure the economic importance of age structure variation for the global economy. We find that even after adjusting for country-specific effects, demographic maturation has been associated with nearly half of the evolution of global per-capita GDP since 1960. We also find that age structure differences can account for just over half of the variation in worldwide per capita GDP (i.e. the lack of sigma convergence) observed since 1960. Taken as a whole, these results complement recent theoretical and empirical work on the importance of population size and economic development and reinforce empirical work linking mature demographic age structures with faster cross-country economic growth rates. JEL Classification: J13, J22, J24, O11, O40.
    Keywords: Age structure, life cycle savings model, cross-country growth.
    Date: 2006–08
  19. By: Urban Jermann
    Abstract: This paper studies the determinants of the equity premium as implied by producers’ first-order conditions. A closed form expression is presented for the Sharpe ratio at steady-state as a function of investment volatility and adjustment cost curvature. Calibrated to the U.S. postwar economy, the model can generate a sizeable equity premium, with reasonable volatility for market returns and risk free rates. The market’s Sharpe ratio and the market price of risk are very volatile. Contrary to most models, the model generates a negative correlation between conditional means and standard deviations of aggregate excess returns.
    JEL: E23 G12
    Date: 2006–08
  20. By: Stefania P. S. Rossi; Guido Pellegrini; Ornella Tarola
    Abstract: Can policies accelerate the convergence path of dualistic economic growth in a single country, offsetting market failures and making growth transmission channels more efficient? A structural dynamic econometric model, has been set up in order to account for these changes. Three are the main sources of growth playing a role in this context: the “neighbourhood” effect, the interaction between the economic environment and the agents' expectations, and the policy impact on economic take-off. The evidence shows that policies strongly boost economicgrowth of a local area and narrow the gap between the regions of a dual economy.
    JEL: C50 C52
    Date: 2006–07
  21. By: Hansen, Bodil Olai (Department of Economics, Copenhagen Business School); Keiding, Hans (Department of Economics, Copenhagen Business School)
    Abstract: We consider a simple model of international trade under uncertainty, where production takes time and is subject to uncertainty. The riskiness of production depends on the choices of the producers, not observable to the general public, and these choices are influenced by the availability and cost of credit. If investment is financed by a bond market, then a situation may arise where otherwise identical countries end up with different levels of interest and different choices of technique, which again implies differences in achieved level of welfare. Under suitable conditions on the parameters of the model, the market may not be able to supply credits to one of the countries. The introduction of financial intermediaries with the ability to control the debtors may change this situation in a direction which is welfare improving (in a suitable sense) by increasing expected output in the country with high interest rates, while opening up for new problems of asymmetric information with respect to the monitoring activity of the banks.
    Keywords: Capital outflow; financial intermediaries; moral hazard
    JEL: D92 E44 F36
    Date: 2006–08–28
  22. By: Jaume Ventura; Fernando A. Broner
    Abstract: This paper presents a theoretical study of the e¤ects of globalization on risk sharing and welfare. We model globalization as a gradual and exogenous increase in the fraction of goods that are tradable. In the absence of frictions, globalization opens new goods markets and raises welfare. We assume, however, that countries cannot commit to pay their debts. Unlike the previous literature, and motivated by changes in the institutional setup of emerging-market borrowing, we also assume that countries cannot discriminate between domestic and foreign creditors when paying their debts. Although globalization still opens new goods markets, we find that it can also open or close some asset markets. The net e¤ect on risk sharing and welfare of this process of creation and destruction of markets might be either positive or negative depending on a variety of factors that the theory highlights.
    JEL: E24 F34 F36 G15
    Date: 2006–08
  23. By: Roth, Felix (University of Göttingen); Schüler, Dana (University of Göttingen)
    Abstract: This paper examines the relationship between trust and economic growth. With the help of panel data we conclude that economic growth is negatively related to an increase in trust. Our result is contrary to works taking a cross section design in which trust is positively related to growth. The relationship is tested in the context of EU countries, OECD countries, transition countries and developing countries. Interpersonal trust and systemic trust is differentiated. The paper tries to explain changes in trust over time to investigate channels through which these have a negative influence on growth.
    Keywords: Social Capital; Trust; Economic Growth; Panel Analyis
    JEL: C23 E01 O40 Z13
    Date: 2006–08–30
  24. By: Bhattacharya, Joydeep; Reed, Robert
    Abstract: Many countries around the world have large public pension programs with significant cross-cohort redistribution. This paper provides a rationale for such programs in a lifecycle framework with search and matching frictions in the labor market. In the model, public pension programs alter the age composition of the labor force by inducing the jobless elderly to retire. This improves the allocation of workers to jobs, raises firm entry and may also improve welfare. By requiring a long history of labor market attachment as a precondition to receiving benefits, these programs raise the future value of current employment for the young. This redistributes bargaining strength and income from the young to the old.
    Keywords: Search, labor market efficiency, unemployment, lifecycle, pensions
    JEL: E0
    Date: 2006–08–23
  25. By: Laarni Bulan; Christopher J. Mayer; C. Tsuriel Somerville
    Abstract: We examine the extent to which uncertainty delays investment and the effect of competition on this relationship using a sample of 1,214 condominium developments in Vancouver, Canada built from 1979-1998. We find that increases in both idiosyncratic and systematic risk lead developers to delay new real estate investments. Empirically, a one-standard deviation increase in the return volatility reduces the probability of investment by 13 percent, equivalent to a 9 percent decline in real prices. Increases in the number of potential competitors located near a project negate the negative relationship between idiosyncratic risk and development. These results support models in which competition erodes option values and provide clear evidence for the real options framework over alternatives such as simple risk aversion.
    JEL: D4 D52 E23 R3
    Date: 2006–08

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