Essays on investment behavior with information frictions

Abstract

This dissertation contains two chapters on the investment behavior under the concern for information frictions. The essays analyze how induced uncertainty can affect firm'’s choices on general investment as well as inventory investment, and can thus reconcile discrepancies in the individual level investment and aggregate investment, and give a novel explanation on the long-standing variance ratio puzzle of output and sales. In chapter 1, we examine the effects of model uncertainty due to a preference for robustness for the joint behavior of inventory, production, and sales in an otherwise standard production cost smoothing hypothesis (PSH) model. We show that introducing robustness have the potential to improve the otherwise standard model’'s performance in the following dimensions: (i) the relative volatility of production to sales and (ii) the correlation between sales and inventories. In this part we also re-estimate the output-sales variance ratios across different sectors, including manufacturing sector, wholesale sector and retail sector. We found that the variance ratios are all above 1 across different categories, which is consistent with previous findings. Also, the correlation of inventory investment and sales varies across these sectors, but they all appear positive in all episodes. Using our estimated parameters and previous findings, we are able to match the two key moments we concern, variance ratio and inventory-sales correlation. In addition, we also showed that introducing RB can better explain the behavior of production, inventories, and sales before and after the Great Moderation. In Chapter 2, the essay adapts Sargent’'s version of Lucas and Prescott’'s model of investment under uncertainty in a competitive industrial equilibrium setting, in which individual firm's capital cost function is proportional to adjustment size and firms make investment decisions subject to state uncertainty. The introduction of state uncertainty due to imperfect observation to demand shocks smooths aggregate investment and leads to additional sluggishness. In the equilibrium, aggregate investment recovers the partial adjustment result, and individual firms adjust investment infrequently with an optimal probability. A general equilibrium setting is also introduced to analyze the general effect of an inattentive firm’'s investment decision on asset price. In the general equilibrium, marginal q increases with the degree of rational inattention, and the relation between Tobin’s q and optimal investment rule under state uncertainty is ambiguous.