RIETI Report April 2016

Uncertainty over business conditions and investment: Evidence from Japanese firms

The Japanese economy has been affected not only by global events such as the global financial crisis and the eurozone crisis, but also by shocks specific to the country including political power transfers and the 2011 Great East Japan Earthquake. Because of the irreversibility and adjustment costs of investment, economic uncertainty has a negative effect on investment. In the April issue of the RIETI Report, we present the column "Uncertainty over business conditions and investment: Evidence from Japanese firms" by Vice President Masayuki Morikawa, and originally written for VoxEU.

Based on data gathered on Japanese firms between 2004 and 2014, Morikawa measured business uncertainty and analyzed its relationship with investments. Unlike the past studies that have focused only on the manufacturing sector, his study encompasses both the manufacturing and non-manufacturing sectors, enabling a comparison between industries. Using his uncertainty measure, he shows that manufacturing firms generally exhibit higher levels of business uncertainty than non-manufacturing firms throughout the sample period. Finally, Morikawa suggests that maintaining a stable macroeconomic environment and avoiding unpredictable conduct of economic policies are essential for promoting private firms' investments.

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Uncertainty over business conditions and investment: Evidence from Japanese firms

MORIKAWA MasayukiVice President, RIETI

In recent years, advanced economies have experienced uncertainty shocks repeatedly, such as the Global Crisis, the Eurozone Crisis, and the ‘fiscal cliff' in the United States (in 2012). The Japanese economy has been affected not only by these global events, but also by shocks specific to Japan including the transfer of political power between the Liberal Democratic Party and the Democratic Party (2009, 2012) and the 2011 Great East Japan Earthquake. Using data from a quarterly business survey in Japan, we construct a measure of business uncertainty and analyse the time-series properties of uncertainty and its relationship with investments.

How to measure economic uncertainty

Theoretically, because of the irreversibility and adjustment costs of investment, economic uncertainty has a negative effect on investment. This mechanism is referred to as the option value of waiting. Empirical studies generally support this theoretical prediction that uncertainty has a negative impact on equipment investment, research and development (R&D) investment, and hiring of employees. In the empirical studies, various proxies of uncertainty have been developed and employed, such as volatility of stock prices, the unexplained portion of macroeconomic variables derived from econometric models, the cross-sectional disagreement of economic forecasts, or the frequency of newspaper articles regarding uncertainty (see Bloom 2014 and Jurado et al. 2015, for surveys).

To read the full text
http://www.rieti.go.jp/en/columns/v01_0056.html

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