Investment and Uncertainty in the G7

Author(s): Joseph P. Byrne and E. Philip Davis

Source: Review of World Economics / Weltwirtschaftliches Archiv, Vol. 141, No. 1 (Apr.,
2005), pp. 1-32
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in theG7
and Uncertainty
Investment
JosephP.Byrneand E. PhilipDavis
Universityf
Strathclyde
Glasgow;Brunei University,
Oxbridge

and investment
Abstract:
workon uncertainty
focuseson one
Empirical
generally
We
of
extend
the
literature
or
one
indicator
uncertainly.
byassessingthe
country
on aggregate
sourcesof uncertainty
impactofa comprehensive
rangeofpotential
acrosstheG7 usingPooledMean GroupEstimation
businessinvestment
(PMGE)
A significant
effect
and GARCHmethodsto modeluncertainty.
negative
long-run
fromexchangeratevolatility
is foundfortheG7 and in poolablesubgroupsinoflong-term
interest
rateshas addiVolatility
cludingall fourlargerEU countries.
investment
in recentyears.Formostestimates,
a one standard
influenced
tionally
alleadsto a 2-4 percentfallin investment
deviationrisein conditional
volatility
alia
declines.
The
results
inter
that
EMU
some
samplesgivegreater
suggest
though
is beneficial
to aggregate
investment.
JELno. E22,F31
rates;nonstationary
Investment;
panelestimation
Keywords:
uncertainty;
exchange

1 Introduction
are increasingly
The benefits
of macroeconomic
emphasizedby
stability
a
academic
This
has
but
also
makers.
followed
underpinnedgrowing
policy
varion macroeconomic
in economicuncertainty
and itseffects
interest
inboththeshortandlongrunis crucially
ables.Outputgrowth
dependent
and thefocusofthispaperis therebusinessinvestment,
uponaggregate
The twomainstrandsof
betweeninvestment
and uncertainty.
lationship
conclusions.
come to different
on thisrelationship
literature
theoretical
and
determination
The calloptionapproachto investment
(Dixit
Pindyck
reducesinvestment
1994)impliesthatincreaseduncertainty
giventheirof investment
projectsand the consequentoptionvalue of
reversibility
Remark:The project was undertakenwhile both authors were at the National Instituteof
Economic and Social Research. The authors wish to thank Paul Ashworth,Ray Barrell,
AndyBlake, StephenHall, DeAnne Julius,Campbell Leith,Nigel Pain, Simon Price,Martin
Weale and other seminar participantsat NIESR and WarwickUniversityfor helpfulsuggestions.This researchwas financedby ESRC project LI 38250122, Fluctuationsand LongTerm Prosperity:A Study of UK and InternationalEconomies. Please address correspondence to E. Philip Davis, Brunei University,Uxbridge,Middlesex, UB8 3PH and NIESR;
e-mail: e_philip_davis@msn.com
2005 Kiel InstituteforWorld Economics

DOI: 10.1007/S10290-005-0013-0

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Review of World Economics 2005, Vol. 141 (1)

In contrast,
earlier
work(Hartman1972;Abel1983)
delaying
expenditures.
thatincreaseduncertainty
raisesinvestment
wherethemarginal
suggested
of
is
an
function
of
and
increasesin the
product capital
prices
increasing
varianceofpriceswillincreasetheexpectedreturn.
Giventhistheoretical
disputethereis a needforempirical
analysis.
Whilethereisanextensive
literature
onuncertainty
andinvestempirical
itis mainlyundertaken
on thebasisofone country
oroneindicator
ment,1
ofuncertainty.
Carruthet al. (2000b) are oftheviewthatthebroadconsensusis thattherelationship
is negative
and thisconsensusemerges
from
a widerangeof modelsand alternative
methodsofproxying
uncertainty.
On theotherhand,Huizinga(1993) suggests
thateffects
varydepending
on thesourceofuncertainty.
results
fora singleinFurthermore,
differing
dicatorsuchas exchangeratevolatility
havebeen foundbyauthorssuch
as Goldberg(1993) and Darbyet al. (1999) dependingon thecountries
measuresofuncertainty
and thedataperiod
studied,methodsofderiving
used.In thispaperwe arguethatthereare good reasonsforusingconditionalvolatility
measuressuchas thosederivedfromGARCHestimation
as
thebestmeasuresofuncertainty
in a forward
lookingsense.
methodshavebecomepopnonstationary
Recently,
paneleconometric
ularin multi-country
macroeconomic
studies.Thesemethods,
whichhave
botha timeseriesand cross-sectional
are
a
means
ofincreasdimension,
of parameter
estimates
whentestinga particular
ingtheefficiency
longrunhypothesis
whilsttakingaccountof potentialnonstationarity.
While
somedifferences
acrosscountriesare to be expected,
whenadoptingthis
it
is
to
test
for
cross-sectional
to enapproach
important
heterogeneity
surethatpanelestimates
arenotbiaseddue to "unreasonable"
poolingof
countries(Pesaranand Smith1995). Takingaccountofthesefactors,
we
conducta multicountry
of
and
investment
a
study
comprehensive
range
of macroeconomic
indicators
of uncertainty
usingPesaran'set al. (1999)
Pooled Mean GroupEstimation(PMGE), and GARCH methodsto deriveuncertainty
measures.We assesslong-term
effects
on investment
of
measuresof conditional
and
short-term
effects
of
our
volatility,
dynamic
whilepayingparticularattention
to
uncertainty
proxieson investment,
whetherlong-runcountryhomogeneity
is acceptedbythedata.The indicatorsused includebothfinancial
variables(equityprices,interest
rates
andexchange
variables(inflation
andindustrial
rates)andmacroeconomic
production).
1 See the excellentreview Carruthet al.
(2000b).
by

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Byrne/Davis:Investmentand Uncertaintyin the G7

does
We cometo theconclusionthatthesourceofvolatility
typically
withexchange
ratevolatility
matter,
beingmostcrucial.Besidesthegeneral
insuchwork,theeffect
ofuncertainty
on investment
interest
isan important
of
the
benefits
of
EMU
since
EMU
is
aspect
membership,
likelyto remove
of
rate
effective
and, possibly,
part
partof long-term
exchange volatility
ratevolatility
as follows.
In Section2
interest
also.The paperis structured
we providea briefoverview
ofthetheoretical
and empiricalliterature
on
and
In
investment.
Section
3
we
address
and
estiuncertainty
specification
mationissues.In Section4 we setoutthedata,Section5 considers
results,
whilstSection6 drawsconclusions.

2 LiteratureSurvey

2.1 Theoryof Investment

and Effects
of Uncertainty
toDixitand Pindyck(1994),theeffect
ofuncertainty
on investAccording
mentstemsfromtheoptioncharacteristics
ofan investment
project,
given
theoptionofdelaying
theprojectanditsirreversibility
oncebegun,together
withtheuncertainty
overfuture
itsprofitability.
pricesthatwilldetermine
The valueoftheoptionstemsfromthefactthatdelaying
theprojectmay
givea moreaccurateviewof marketconditions.The call optionimplies
a difference
betweenthenetpresent
value(NPV) ofan investment
and its
current
worthto theinvestor.
To lead to expenditure,
theNPV has to exceedzeroso as to covertheoptionvalueofwaiting.
The expectation
is that
to
in
would
lead
a fall
to
heightened
uncertainty,
byleading delay projects,
in aggregate
investment.
Theremayalso be threshold
i.e. ratesof
effects,
belowwhichinvestment
is notundertaken,
on investors'
return,
depending
riskaversion.Abelet al. (1996) extendedthistheoryof irreversibility
to
showthattherecouldbe botha calland putoptionfeature
in investment,
intermsofoptionsto expandor contract
thecapitalstockin thefuture.
The literature
is notunanimousin suggesting
a negative
effect
ofunon investment.
Hartman(1972) andAbel(1983) showcounterto
certainty
theabovethatwherethereis perfect
and constantreturns
to
competition
scaleas wellas symmetric
an
increase
in
costs,
adjustment
uncertainty
may
also raisethevalueofa marginal
unitofcapitaland hencetheincentive
to
invest.
Leeand Shin(2000) arguethatthebalancebetweenthepositiveand
of uncertainty
negativeeffects
maydependon thelabourshareof firms'
costs.

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ReviewofWorldEconomics2005,Vol. 141 (1)

Giventhesecontrasting
theoretical
as wellas ambiguity
as to
results,
whereuncertainty
at a macrolevel,empiricalworkis vital.We
originates
nowgo on to reviewempiricalmethodsand studiesin termsofsourcesof
and theiruse in investment
beforeundertaking
our
functions,
uncertainty
ownempirical
work.
2.2 EmpiricalWorkon Investment
and Uncertainty
An extensive
on investment
and uncersurveyof theempiricalliterature
taintyis providedin Carruthet al. (2000b).Overall,theysuggestthereis
a broadconsensus
thattheeffect
fromproxymeasures
ofuncertainty
on aginvestment
is
is
for
This
a
wide
of
models
and
various
gregate
negative.
range
methodsofproxying
Ourintention
is nottorepeatthatsurvey,
uncertainty.
butrather
to providea thematic
overview
for
givingsufficient
background
our
results
and
contrasts
with
earlier
as
well
studies,
understanding
possible
as to reference
morerecentwork.
thereareissuesinchoosingthesource
wherethereare
First,
ofuncertainty
oftenconflicting
theoretical
arguments.
Takingtheexampleofshareprice
itisarguedinCarruth
etal. (2000b)thatuseofstockmarket
based
volatility,
measures
reveal
cash
flow
for
the
but
are
not
relevant
firms,
may
uncertainty
indicators
offuture
economicshocksand policychanges.Moreover,
stock
to bubblesratherthanreflecting
fundamentals.
pricesmaybe vulnerable
Hencetheyarguethatmacroeconomic
variablessuchas price,outputand
are oftenpreferred
instead.One could querythis
exchangeratevolatility
since
share
take
into
account
all information
relevant
to
approach
prices
thefuture
ofthefirm(orata macrolevelthecorporate
sector).
profitability
onecanarguethatinvestment
is discounted
Furthermore,
bythelong-term
interest
rateplusa riskpremium,
wherethelattermaybe linkedto equity
market
viewssuggest
(Davis and Madsen2001). Suchconflicting
volatility
a need to takea comprehensive
empiricalviewofpossiblemeasuresand
theirimpact.
Asregards
measurement
authorsthathaveusedARCHor
ofuncertainty,
GARCHmeasures
ofmacroeconomic
variables
whenmodelling
investment
includeHuizinga(1993) and Price(1995).Huizinga(1993) considers
conditionalvolatility
ofUS inflation,
realwagesand realprofits
and generally
findsa negativeeffect
on investment.
Price(1995) utilizestheconditional
varianceof the growthrateof GDP, and findsa negativeeffecton UK
investment
thereis
manufacturing
laggedtwice.The questionofwhether
a different
effect
fromforward
and backwardlookingmeasuresofuncer-

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Byrne/Davis:Investmentand Uncertaintyin the G7

hasbeenraisedbyFerderer
toproducea forward
( 1993). He attempts
tainty
For
lookingmeasurebasedon theriskpremiumfromthetermstructure.
theUS he findsthattheeffect
on investment
is negative.
Driverand Moreton (1991) modeluncertainty
usingthestandarddeviationof 12 months
forward
ofoutputgrowthand inflation
across12 forecasting
predictions
teams.Theyfinda negative
fromoutputgrowth
on investlong-runeffect
mentbutno long-run
effect
frominflation
on investment.
Goldberg(1993)
and Campa and Goldberg(1995) derivedtheirmeasureofexchangerate
fromthestandarderrorsoftheresidualsfroma movingaverage
volatility
oftheexchange
rateusingUS data.
representation
at
ratevolatility
and investment,
Lookingspecifically exchange
Darbyet
al. (1999) usinga modelbasedon Dixitand Pindyck(1994) suggestthat
therearesituations
whereexchange
rateuncertainty
willdepressinvestment
andsituations
whereitwillnot.In theempirical
sectionoftheirpaperDarby
etal. (1999)find,usinga neoclassical
model,Tobin'sQ andmovingaverage
rate
that
has a significant
and negativeimvariance,
exchange
uncertainty
on
investment
for
the
and
France.
There
areadditional
US, Germany
pact
effects
whicharenegative
forItalyand theUK. Therearenegative
dynamic
effects
fortheUS, France,Italyand theUK.
misalignment
Serven(2003) usingGARCHmeasuresofuncertainty,
findsa negative
and highlysignificant
of
real
rate
on priimpact
exchange
uncertainty
vateinvestment
in a sampleofdeveloping
aftercontrolling
for
countries,
standardinvestment
The impactis largerat higherlevelsof
determinants.
- in linewiththeanalytical
literature
'threshold
uncertainty
underscoring
effects'.
the
effect
on
investment
of
real
rate
uncerMoreover,
exchange
is shapedbythedegreeoftradeopennessandfinancial
tainty
development:
are
associated
witha more
higheropennessand weakerfinancial
systems
link.2
uncertainty-investment
significantly
negative
We suggestthatthereare a numberoflacunaein theexistingmacro
thatwe shallseekto fillin thefollowing
sections.Studiestendto
literature,
be fora singlecountry,
indicator
and measurement
method.Unlikemany
studiescitedabove,welookbothacrossa rangeofindicators
andalsoutilize
inlonga panelmethodology
fortheG7 countries,
for
testing homogeneity
2 Some
disaggregatestudies, including Leahy and Whited (1996), Driver et al. (1996),
Guiso and Parigi (1999) and Temple et al. (2001) also found negative effectsof uncertaintyon investmentin at least some industries.For example Temple et al. (2001) found
that UK industrialsurveyresponsessuggestedexternalfinanceconstraintsand uncertainty
about demand were factorslimitinginvestment,but that the formerdepended on concentrationin the industry.

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Reviewof WorldEconomics2005,Vol. 141 (1)

Wenowgo on to describeourapproachto
runresponses
acrosscountries.
and uncertainty.
therelationship
betweeninvestment
estimating
3 Specificationand EstimationIssues
3.1 Measuresof Uncertainty
Asnotedabove,inempirical
istypically
applications,
uncertainty
proxiedby
measuresofvolatility.
Thissectionprovidesa briefdiscussionofsuchmeasures.We concludethesectionwitharguments
whichfavourconditional
measures
such
as
deviGARCH,againstmovingaveragestandard
volatility
ations.
In theGARCH(p,q) modelintroduced
(1986)weconsider
byBollerslev
theinformation
setYt-uwhichcontainsall information
on thevariableyt
untiltimet- 1.Alsowe assumethetimeseriesytcanbe describedas
yt'Yt-i=(ht)^t,

<~ NID (0,1)

ht= a0+ /rt,+J2iht_u

(1)

(2)

whereht is the conditionalvariance.3Givena coefficient

on thelagged
error
than
will
tend
to
withlarge
zero,volatility
cluster,
ot'greater
squared
residualsfollowing
otherlargeresiduals,
but of unpredictable
sign,while
a random,normally
distributed
variationin theconditionaldistribution
distribution
(errorvariance)givestheunconditional
(errordistribution)
fatter
tailsthanthenormaldistribution.4
MostoftheGARCHstudiesintheliterature,
forstockreturns,
theterm
structure
orexchange
havefounda significant
of
both
short
and
rates,
degree
shock
with
thus
for
data,
long-run
persistence highfrequency
accounting
theclustering
ofvolatility
whichischaracteristic
ofsuchmarkets
(Bollerslev
et al. 1992). Studiesof inflation
havefoundsimilarresults(Engle1983).
3 To ensurea well-defined
in theinfinite
orderAR representaprocess,all theparameters
tionmustbe nonnegative,
whereit is assumedthattherootsofthepolynomial
lie outside
theunitcircle.Fora GARCH(1,1), a sufficient
lag lengthin mostapplications
according
to Bollerslev
et al. (1992),thisamountsto ensuring
thatboth and are nonnegative.
It followsalso thatytis covariancestationary
ifand onlyifct' + ' < 1.
' on the laggeddependentvariableand settingthe conditional
Usingthe coefficient
varianceconstant,GARCH enablesa long-runresponseof the conditionalvarianceto
shocksto be calculated.
ao/[l - oti- '] is themeanlevelofvolatility.

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Byrne/Davis:Investmentand Uncertaintyin the G7

Therearenumerous
variants
on thebasicGARCHwhichallowinteraliafor
a distinction
short-andlong-run
between
GARCH)
(components
volatility
in effects
Given
our
and asymmetries
ofvolatility
GARCH).
(exponential
a rangeofindicators,
we retainGARCH(1,1)- in
focushereis on testing
workon exchange
ratevolatility
further
(ByrneandDavis2003a)wesetout
Wemaintain
that
results
approaches.
complementary
usingthesealternative
here.
the
basic
results
do
not
controvert
presented
they
to theuse of GARCH or variantsare typesof moving
An alternative
oftheseriesin question.One such
orvariances
deviations
averagestandard
based on thevariancewas adoptedby Kenenand
measureof volatility
Rodrick(1986) and Darbyetal. (1999):

KR=rjg(Aln^)2]2.

(3)

canalsobe derived
movingaveragemodel,
usingan autoregressive
Volatility
as in Goldthe
model's
deviationof
residuals,
theproxybeingthestandard
papers:
berg(1993) and subsequent
ERt= aiERt-i +st + 'St-x.

(4)

Some authorssuchas Pindyckand Solimano(1993) also workwiththe

timeseries.
deviation(SD) oftherelevant
movingaveragestandard
betweenGARCH (whichmeasuresconWe arguethatthedistinction
and movingaveragebasedvolatility
(a measureofunditionalvolatility)
thattheGARCH
and
one,
is a potentially
conditional
important
volatility)
ofuncertainty
characteristics
moreofthetheoretical
basedmeasureoffers
this,considerthedismeasurewould.To motivate
thanan unconditional
Risk
duetoKnight(1921) betweenriskand uncertainty.
tinction
originally
meaa
will
can be definedas thedangerthata certaincontingency occur,
tobeingreducedto objective
eventssusceptible
sureoftenrelatedto future
ofa future
term
is
a
while
appliedtoexpectations
probabilities, uncertainty
a
as
such
be
cannot
changein
eventto whichprobability
applied,
analysis
of
The
crisis(Shafer1986).
response an uncerpolicyregimeor a financial
- mayappearout of
thereto
tainmarket and theresponseofinvestment
to
ifitleadsparticipants
causesofa givenstimulus
scalewiththeproximate
decisions.
their
form
changethewaythey
alone maymerely
unconditional
In thiscontext,
volatility
heightened
shocks,i.e.
a greaterincidenceof largerandomand independent
reflect
as to thesituation
withouta changein underlying
perceptions
risk,
greater

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Review of World Economics 2005, Vol. 141 (1)

on thepartoffirms
investment.
On theotherhand,heightened
considering
conditional
besidesindicating
risk,mayalsoindicategreater
(imvolatility,
thedirection
on thepartofthemarketregarding
measurable)uncertainty
ofthevariableand theintentions
oftheauthorities,
includingmarketreforshockstohavepersistent
sponsestoshocksperse5(an increased
tendency
investment.
More
effects
on themarket)whichmaybe morelikelytoaffect
conditional
of
concentrated
periods
volatility
generally,
volatility
highlights
whichmightbe expectedto maximizeuncertainty
and hencetheoption
whiletherollingmeasurescould
valueofwaitingto undertake
investment,
withoccasionaloutliersthatfirms
justbe capturing
background
volatility
learntolivewith.A similarpointis madebyServen(2003),whoconsiders
as opposed
use ofGARCHessentialto measureexchangerateuncertainty
to "samplevariability".
3.2 Specification
Functions
of Investment
WefollowBean(1981),DriverandMoreton(1991) andDarbyetal. (1999)
in estimating
modelsof investment
dynamicerrorcorrection
including
bothshort-and long-runtermsin output,investment,
averageQ and the
realusercostof capital.Consistent
withtheseauthors,we testforlongrunhomogeneity
ofoutputas impliedbytheCES production
function.
As
we
introduce
investment
models,
background briefly
empirical
including
theflexible
accelerator
modelandTobin'sQ theory
of
model,theneoclassical
investment.6
Theflexible
accelerator
modelis represented
bytheshort-and
betweeninvestment
and output,suchthata desired
long-runrelationship
is maintained.
Thisignores,
however,
output/capital
relationship
possible
substitution
effects
betweenfactorinputs,unliketheneoclassicalmodel
of Jorgensen
effects
the
(1963). To takeaccountof possiblesubstitution
neoclassical
modelincorporates
factor
pricesintheformoftheusercostof
capital,Q. Hencethedesiredcapitalstock,K*yis as follows

whereYtis output, is a constantand is theelasticity

of substitution
betweenfactor
inputs.
5 See also Kurz and Motolese
(2001).
6 Caballero
(1999) provides a comprehensivesurveyof the investmentliterature.

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Byrne/Davis:Investmentand Uncertaintyin the G7

As discussedin Carruthet al. (2000a),empirical

investigators
typically
assumeeitherthatnetinvestment
is determined
as a distributed
lagprocess
ofchangesinthedesiredcapitalstock,or thatthereareexplicitcostsofadfunction
forempirical
Then,itispossibletoobtainan investment
justment.
estimation
thatequatesthelevelofinvestment
to lagsofthechangein the
inthefollowing
levelofoutputandtheusercostofcapital.Thisisillustrated
interms
fourequations,
where(6) and (7) showtheevolution
ofinvestment
rateandg isthesteadystate
ofthecapitalstock(where is thedepreciation
thisinto(5) and (9) setsout theequationin
growthrate),(8) integrates
form:
logarithmic
(6)
It = 8Kt+ dKt
=
(7)
It (g + 6)Kt
=
(8)
It a(g + S)Yt/C?
=
In(It) 0o+ 0i In(Yt) In(Q) .
(9)
literainvestment
in thetheoretical
A thirdapproachoftenemphasized
ofthe
theimportance
turewas introduced
byTobin(1969) and highlights
to thecapitalstock,or Q as opvaluationofthefirmrelative
stockmarket
thereistheimplicit
areperfect,
markets
Where
factor
to
capital
prices.
posed
conon market
information
will
value
that
market
incorporate
assumption
we
ofcostsorfinalprices.Accordingly, test
forexample,
ditions,
uncertainty
as a variantwhenassessingtheimpactofuncertainty
forTobin'sQ effects
on investment.7
3.3 Econometric
Approach
to ourestimation
approach,panelmethodshavebecomepopular
Turning
and more
macrodata setssincetheyprovidea greater
in cross-sectional
individual
than
hence
and
information
country
varied
set,
efficiency,
greater
methodsforestimating
studies.Thereare twotraditional
panelmodels:
separateregressions
involves
andpooling.Theformer
running
averaging
7 We use the ratio of the
capitalizedfinancialvalue of the firmto the replacementcost of
is equivalent to the theoreticallyappropriatebut unobservable
This
or
average Q.
capital
to certain
marginalQ subject to the production and adjustmentcost functionsadhering
SensenSee
market
no
is
there
that
alia
inter
conditions
power).
(implying
homogeneity
brenner(1991), Cuthbertsonand Gasparro (1995) and Cooper and Ejarque (2001) forevidence on the usefulnessof Tobin's Q in empiricalmodelling. In particular,Cuthbertson
and Gasparro find that although Q is importantfor long-run UK investment,it is not
statistic.
a sufficient

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10

Review of World Economics 2005, Vol. 141 (1)

and calculating
coefficient
means.8A drawbackto averaging
is thatitdoes
notaccountforthefactthatcertainparameters
maybe equal overcrosssections.Alternatively
we couldpool thedata and assumethattheslope
coefficients
anderrorvariances
areidentical.
whereas
theremaybe
However,
theoretical
and empirical
reasonstopresumethatthelong-run
coefficients
arehomogeneous
overthecross-section,
thereareveryfewpractical
casesin
whichtheshortrundynamics
anderrorvariances
wouldbe homogeneous
too.Forexample,inthecaseofinvestment,
itcanbe arguedthatdifferences
in industrial
and tradestructure
suchas existbetweentheG7 wouldbe
theshort-run
rather
thanlong-runresponses
to uncertainty
likelyto affect
their
effects
on
the
life
of
(givene.g.
optimal
capitalgoods). We would
moregenerally
that
the
PMG
argue
approachmaybe seenintheinvestment
functionas modelingthe supplyside,wherebyfirmshave similarlongtermreactionsto economicvariables,
givena commonobjectiveofprofit
maximization
in thelongterm,whilein theshorter
terminstitutions
may
a
role
as
of
(such scope liquidityprovidedby relationship
play
banking)
We notethatglobalization
and growthof
leadingto differing
dynamics.
multinationals
makesa commonlong-runresponseto volatility
plausible
inthecaseofexchange
ratesmultinationals
also
be
sensitive
(although
might
to covariances
betweenbilateral
exchangerates).
to use thePesaranet
Followingthispoint,we considerit appropriate
al. (1999) PMGE method,whichis an intermediate
case betweentheavand involvesaspectsofboth.
eragingand poolingmethodsofestimation
The methodrestricts
thelong-runcoefficients
to be equal overthecrossbut
allows
for
the
short-run
coefficients
and errorvariancesto
sections,
differ
acrosscross-sections.
We can therefore
obtainpooledlong-run
coefficients
and averagedshort-run
errorcorrection
as
an
indication
dynamics
ofmeanreversion.
The PMGE is basedon an Autoregressive
Distributive
LagARDL(p,q,
model
..., q)

i=l

;=0

ya= + te-; + i + Ziu

()

wherext(k 1) is thevectorofexplanatory
variablesforgroupi,,representsthefixedeffects,
thecoefficients
ofthelaggeddependent
variables,
,
* See for
example the Mean Group Estimator(MGE) method advanced by Pesaran and
Smith(1995).

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Byrne/Davis:Investmentand Uncertaintyin the G7

11

arescalarsandJ,jare(fc 1) coefficient
vectors.T mustbe largeenoughso
thatthemodelcanbe estimated
foreachcross-section.
as:
Equation(10) canbe reparameterized

+ feu + KjAnH
A)fe= -
7=1

()

q-'

+ 8-jXit-j+ i + ZiU
7=0

where
{ = -(l - EjLi 9),ft= ^ % *= - ^+ /,andf.=
In additionwe assumethatthe residualsin (11) are independently
thanzeroand
acrossi and t withzeromean,variancegreater
distributed
therootsofequation(11) mustlieoutside
fourth
moments.
finite
Secondly,
ensuresthat0, < 0, and hencethat
theunitcircle.The latterassumption
between
a
thereexists long-run
by
ynandxzidefined
relationship
= -(fl-/*)*t + *to.
yfr

(12)

isequalto = ,= -(^/, which

coefficient
Thelong-run
homogeneous
likelihood
isthesameacrossgroups.ThePMGEusesa maximum
approach
The lag length
to estimatethemodeland a Newton-Raphson
algorithm.
theSchwarz's
forthemodelcanbe determined
Bayesian
using,forinstance,
Criteria.
Information
ofthePMGE is to makethelong-run
Forourpurposes,thekeyfeature
whileallowingfortheheterogeneous
dynamics
homogeneous
relationships
a joint
first,
Wetestforlong-runhomogeneity
and errorvariances.
using,
Likelihood
a
second
and
for
et
al.
Hausmantest(seePesaran
(1996) details),
Ratioapproach.The Hausmantestis based on the null of equivalence
If we rejectthe null,we reject
betweenthe PMG and MG estimation.
whilesignificant
cross-sections'
our
of
long-runcoefficients,
homogeneity
be indicativeof
would
estimators
two
our
between
difference
statistical
for
test
Ratio
The Likelihood
long-runparameter
panelmisspecification.
has homogeneity
and
this
in
conventional
more
is
setting
heterogeneity
always
as thenullhypothesis
(Hsiao 2003). The LikelihoodRatiostatistic
of
al.
et
Pesaran
in
the
(1999) panelstudy aggregate
rejectshomogeneity
test
a muchmorestringent
and,as such,can be considered
consumption
thantheHausmantest,whichtypically
acceptspoolability
forpoolability
thatthe
in thePesaranet al. study.In Pesaranet al. (1999),it is suggested

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12

ReviewofWorldEconomics2005,Vol. 141 (1)

low poweroftheHausmantestmaybe due to thebroadstandarderrors

associatedwiththeMGE. Henceevidencefroma HausmantestthatPMG
is notsignificantly
different
fromMG estimation
maynotbe a reflection
of PMG beingconsistent
but merelythatMG is inefficient.
Giventhese
we focuslargelyon the LikelihoodRatiotestin the results
arguments,
sectionbelow.
AnotherreasonforutilizingthePMGE in our empiricalworkis that
theestimated
coefficients
in themodelare not dependentupon whether
thevariablesare1(1) or1(0). Pesaranand Shin(1998)present
MonteCarlo
evidencethatARDL approachbased on thedeltamethodcan be reliably
used in smallsamplesto estimateand testhypotheses
on the long-run
coefficients
in caseswhetherthereis a mixtureof 7(1) and 1(0) regressors.We also calculatedtheMGE, whichis an averageof theindividual
coefficients.
Thisprovidesconsistent
estimates
ofthemeanofthe
country
coefficients
are
inefficient
if
long-run
althoughthey
slope homogeneity
holds.Underlong-runhomogeneity,
PMG estimatesare consistent
and
efficient.
4 Data
In termsofmacroeconomic
dataneededfortheinvestment
weuse
function,
timeseriesfortheG7 countries,
the
US,
Canada,
quarterly
namely
Japan,
the UK, Germany,
Franceand Italy.We use the OECD BusinessSector
Databasetoobtaindataforrealbusinessinvestment,
IB,realbusinesssector
output,YByand therealbusinesssectorcapitalstock,KB. Privatesector
oftenincludehousinginvestment
and thehousingstock,which
aggregates
has a different
to
business
investment.
Problemsoflackof
cyclicalpattern
with
investment
would
arise
for
alternatives
to outputsuchas
congruence
salesgrowth.
Businesssectordataalso overcomes
theproblemsoftransfer
frompublicownership
businesssectorcapital,investment
and
byincluding
of
sector
of
outputirrespective
ownership.
we use thenonfinancial
Meanwhile,
corporatesectorcapitalstockfor
Tobin'sQ, Q, consistent
withtheequitystock,whichis obtainedfromsectoralfinancial
accountspublished
bythevariousnationalstatistical
agencies
(fora discussionofthesedatasee Byrneand Davis (2003b)). CostofcapitaldataarefromtheNiGEMmacromodel
database.The costofcapitalis
calculated
as thetax-adjusted
purchasepriceofa unitofcapital,multiplied
costofcapitalplusthedepreciation
rate.
bytherealpost-taxfinancial

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Byrne/Davis:Investmentand Uncertaintyin the G7

13

CPI data,longForgenerating
uncertainty
proxies,we utilizemonthly
effective
ratedata,nominaland realtradeweighted
terminterest
exchange
for
theG7
market
index
and
the
stock
rate9data,industrial
production
Datastream.
over1968-2001.Theseare obtainedfromPrimark
countries
varianceofthemonthly
weusetheconditional
functions
In ourinvestment
ofthe
interest
oflong-term
difference
rates,DLR, and thelog-difference
industrial
nominaleffective
DER,
rate,
DEQ,
proequityprices,
exchange
effective
real
the
and
consumer
DP,
duction,DIP,
exchangerate,
price10,
of
interests
the
In
3.2.
in
Section
out
DRER,estimated
usingGARCHas set
details
wedo notprovidedetailsofourGARCHestimates
(full
conciseness,
resultsare availablein Byrneand
varianceestimation
of our conditional
were
GARCHeffects
to noteherethatsignificant
Davis (2002)). It suffices
conditional-variance
in
the
ineachcaseandthattheGARCHprocess
present
withot'+ < 1. We note,following
equationwas covariancestationary
a model-dependent
outcome,
although
Engle(1983)thatGARCHgenerates
conditional-mean
the
of
equationsuftheapproachadopted, differencing
standard.
is
to avoidautocorrelation,fairly
ficiently
to preclude
in particular
In evaluatingthedata priorto estimation,
we use relatively
a stationary
powerfulunitroottestsusing
regressand,
the
and
developedin Ng and
local GLS detrending adopt
testingstrategy
testresultsaregiven
the
of
a
detailsand summary
Perron(2001). Further
and businessoutputare i(l), as
in TableI.11Logsofbusinessinvestment
for
specifications
aremostofthetimesseriesin levelsused in traditional
and Gasparro
withCuthbertson
So too isTobin'sQ, consistent
investment.
also
are
7(1),
measures
typically although
volatility
(1995).Theconditional
ratevolatility
real
exchange
evidencethatequitypriceand
thereisconsistent
the
measuresare1(0). As noted,Pesaranand Shin(1998) emphasizethat
Our
ARDL approachis robustto theinclusionof1(1) and J(0) regressors.
with
thatwe do notstartouranalysis
fromtheunitroottestsuggest
results
is
evidence
further
In thisregard,
evidenceof an unbalancedregression.
to ourlong-runrelationships.
providedbelowofmeanreversion
9 We considerthe effectiverate to be more appropriatethan bilateralrates such as those
and relatedvolatilityapprowith the US dollar given it distributesexchange rate changes
the countryconcerned.
of
markets
and
the
across
import
priately
export
*Ui10 We note thatthereare argumentsforusing volatilityot tne wnoiesaie price
of the CF1 and
economic
wider
the
on
significance
based
was
choice
The
CPI.
than the
statusas a targetof monetarypolicy.
11 Full details are available in Byrneand Davis (2002).

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14

ReviewofWorldEconomics2005,Vol. 141 (1)

Table1: UnitRootTests
US

CN

FR

GE

IT

JP

UK

'n(IB)
ln(iB)*
ln(YB)
ln(YB)*
Tobin'sQ

1(1)
/(I)
7(1)
/(I)
1(1)

1(1)
1(1)
1(1)
7(1)
1(1)

1(1)
/(I)
1(1)
1(1)
1(1)

1(1)
1(1)
1(1)
/(D
1(1)

KD
1(1)
1(1)
/(I)
1(1)

1(1)
1(1)
1(1)
/(I)
KD

1(1)
1(1)
1(1)
KD
KD

Usercost
Usercost*
rate
Longinterest
rate*
Longinterest
CV(DER)
CV(DER)*
CV(DP)
CV(DP)*
CV(DEQ)
CV(DEQ)*
CV(DIP)
CV(DJP)*
CV(DRER)
CV(DRER)*
CV(DLR)
CV(DLR)*

/(I)
7(1)
7(1)
7(1)
7(1)
7(1)
7(1)
7(0)
7(0)
7(0)
7(1)
7(1)
7(0)
7(1)
7(0)
7(1)

7(1)
7(1)
7(1)
7(1)
7(1)
7(0)
7(1)
7(0)
7(1)
7(1)
7(1)
7(1)
7(0)
7(0)
7(0)
7(1)

7(1)
7(1)
7(1)
7(1)
7(1)
7(0)
7(1)
7(1)
7(0)
7(1)
7(1)
7(1)
7(1)
7(1)
7(1)
7(1)

7(1)
7(1)
7(0)
7(1)
7(1)
7(1)
7(0)
7(1)
7(0)
7(1)
7(1)
7(1)
7(0)
7(1)
7(0)
7(0)

7(1)
7(1)
7(1)
7(1)
7(1)
7(1)
7(1)
7(1)
7(0)
7(0)
7(1)
7(1)
7(1)
7(1)
7(1)
7(0)

7(1)
7(1)
7(1)
7(1)
7(1)
7(1)
7(1)
7(1)
7(0)
7(0)
7(1)
7(1)
7(1)
7(1)
7(1)
7(0)

7(1)
7(1)
7(1)
7(1)
7(0)
7(0)
7(1)
7(1)
7(0)
7(0)
7(0)
7(1)
7(0)
7(0)
7(1)
7(1)

Tobin'sQ*

/(l)

KD

KD

KD

KD

KD

KD

Asterisk
Note:Sampleperiod1973:1-1996:4.
(*) indicatestrendin unitrootspecification.
evidence
The tablesummarizes
variancefromGARCHestimation.
CV(.) is theconditional
fromByrneand Davis (2002) including:MZa and MZt modifiedPhillips-Perron
tests;
and Stockfeasiblepointoptimaltest
a modified
test;Elliott,Rothemberg
Sargan-Bhargava
test.
(ERS Pt); a modified
Dickey-Fuller
pointoptimaltest;and DF-GLStheaugmented

5 Results
5.1 Estimationof Investment
FunctionswithoutUncertainty
Followingthediscussionabove,in thissectionwe developa baselineinvestmentfunctionwhichcan be extendedfortestingthe long-runreand investment
lationshipbetweenuncertainty
usingGARCH to derive
conditionalvolatility.
We assess an acceleratorbased investment
function (testingforadditionalcost of capitaland Tobin'sQ effects)using
thePMGE fordynamicheterogeneous
panelsas wellas theMGE based
on averaging
of individual-country
results.In addition,we haveheteroestimateddynamics,
criteria.
Followgeneously
specified
by information

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Byrne/Davis:Investmentand Uncertaintyin the G7

15

and Gasparro(1995) and Carruthet al.

ingtheapproachofCuthbertson
the basic equationis as fol(2000a) to modellinglong-runinvestment,
lows:
In(IB)it= 4>i(In(IB't_x - % - In(YB)it)

(13)

+ ^ In(JB)f
H + <Pji*In(YB),H + siu
wherein variantswe add to thelongand shortruntheadditionalvarirate.Table2 fointerest
ablesTobin'sQ, theusercostand thelong-term
It showsthat
of theestimates.
cusessolelyon thelong-runcomponents
on outputis statistically
thelong-runcoefficient
irrespective
significant,
ofwhichothervariablesare includedin thespecification.
Also,theerror
with
whichis consistent
and negative,
termis alwayssignificant
correction
is
a nonspurious
relationship,
althoughtheimpliedspeedof adjustment
functions.
However,theneoslow,as is typicalof estimatedinvestment
costmeasuresof investment,
classicalopportunity
namelytheusercost
interest
and long-term
rates,haveoftenthewrongsignand arealwaysinand positivein signusingthePMGE.
Tobin'sQ is significant
significant.
interestrate
Whereasit can be arguedthatomissionof the long-term
withmanyotherempiricalstudiessuch as
it is consistent
is surprising,
is thattheimpactofmonetary
Chirinko(1993).12The implication
policy
takesplacevia outputand also (whenincluded)Tobin'sQ. We also acis fairly
thatthepanelspecification
simplecomparedwithwhat
knowledge
sourcesavailable
with
individual
is feasiblefora singlecountry
equation
thePMG apof
in
terms
we do notethat
However,
dynamics
nationally.
in responses(notshown
diversity
proachallowsformarkedcross-country
in detail).
It is emphasizedin thedynamicpanelliterature
developedin Pesaran
al. (1999) thatit is
et
Pesaran
and
and Smith(1995), Lee et al. (1997)
Thispotential
thereis slopeheterogeneity.
to considerwhether
important
in
ofourresults,
theusefulness
canaffect
ofourcross-section
characteristic
is
a
There
coefficients.
estimated
our
bias
it
degree
pooled
particular, may
of dispersionof countryslopesin our results:The LikelihoodRatiotest
levelwhenwe include
at the5 per centsignificance
rejectshomogeneity
12 Also

Darby et al. (1999) only find a cost of capital effectfor France among the G5,
while Cuthbertsonand Gasparro (1995: 938) note that "time series studies have not yet
succeeded in yieldingrobusttax effectsvia the cost of capital".

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Review of World Economics 2005, Vol. 141 (1)

16

Function
Table 2: Basic Investment
ln(YB)
PMGE
MGE
PMGE
MGE
PMGE
MGE
PMGE
MGE
PMGE
MGE
PMGE
MGE
PMGE
MGE

1.367
(t = 24.610)
1.393
(18.322)
1.247
(29.271)
1.250
(10.998)
1.247
(26.037)
1.482
(6.757)
1.346
(24.047)
1.443
(15.648)
1.258
(26.526)
1.218
(11.578)
1.359
(24.150)
1.359
(13.857)
-

Tobin's User Long-term Error

rate correction
cost interest
Q
0.166
(3.233)
0.388
(0.743)
0.169 -0.005
(3.243) (0.013)
0.292
0.381
(0.375) (0.319)
-0.523
(-0.931)
0.120
(0.191)
0.002
0.171
(-0.468)
(3.286)
0.006
0.380
(-0.994)
(0.968)
-0.002
(-0.385)
-0.002
(-0.253)
8.948
(5.554)
7.446
(1.688)

-0.082
(-6.461)
-0.092
(-5.818)
-0.091
(-6.908)
-0.103
(-6.043)
-0.089
(-6.550)
-0.117
(-7.371)
-0.083
(-6.543)
-0.103
(-7.613)
-0.092
(-7.018)
-0.120
(-7.158)
-0.082
(-6.608)
-0.102
(5.690)
-0.010
(-1.199)
-0.033
(-3.023)

MLL

xlR{.}

xjj[.}

0.20
8.45
1648.783
<1653.010> [p = 0.21] [0.65]

1653.317
<1666.087>

25.54
[0.01]

0.20
[0.90]

1650.481
<1678.085>

55.21
[0.00]

3.34
[0.34]

1644.076
<1651.366>

14.58
[0.28]

1.47
[0.48]

1653.400
<1673.014>

39.23
[0.00]

na

1651.637
<1659.466>

15.66
[0.21]

II. d.

1484.742
<1491.177>

12.87
[0.05]

0.13
[0.71]

Note:Estimated
coefficients
at the5 percentlevelin bold.The dependent
variableis busisignificant
ness investment,
fromvariantsof equation(13).
IB, and the tableshowsthe long-runcoefficients
Businessoutputis ln(YB). Estimation
is made byPMG and MG. Sampleperiod1973:1-1996:4.The
ARDL lag structure
is determined
Criteria.
bytheSchwarz'sBayesianInformation
xlR{.} denotesthe
LikelihoodRatiostatistic,
of our cross-sections.
largevaluesrejectpoolability
/#{.} is theHausman
testforpoolability
whichis a testforthe equivalenceof PMGE and MGE. If thenullhypothesis
is
of cross-sectional
accepted(i.e. p-valuegreaterthan0.05) we can accepthomogeneity
long-runcoefficients.
As discussedin Pesaranet al. (1996) thereis no guarantee
thatthedifference
betweenthe
varianceofthemeangroupand pooledestimator
usedto calculate#{.}is positivedefinite
(suchresultsaredenotedherebyn.a.). t-statistics
basedon asymptotic
standarderrorsarein parentheses
().
MLL is in
p-valuesare in squarebrackets[]. MLL is the maximizedlog likelihood,unrestricted
brackets<>.

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Byrne/Davis:Investmentand Uncertaintyin the G7

17

Giventhatthemostsimple
outputand Tobin'sQ in our specification.13
specification
acceptsbothtestsforpoolability,
xlR{6) = 8.45 [0.21],and
aresignificant
forbothestimators
weinitially
concentrate
slopecoefficients
on thelong-runequilibrium
with
in
relationship outputonly our panel
A
Tobin'sQ is notedin Section5.3
study. sensitivity
analysisreintroducing
belowallowingus to assesswhether
inclusionof outputand uncertainty
leads
bias.
to
omitted
variables
only
significant
Wecannotacceptthehypothesis
thatthecoefficient
on outputis equal
tooneinourinvestment
whether
ornotweincludethelong-term
function,
interest
rateor Q, sincetheestimatedoutputcoefficient
reportedin the
errors
secondtoprowofTable2 is morethantwostandard
awayfrom1.00.
Cuthbertson
and
et
al.
and
Carruth
(2000a)
Gasparro(1995)both
Although
is accepted,theyalso
findevidencethatthenullof outputhomogeneity
on outputis greaterthan
reportevidencewheretheestimatedelasticity
has
Cuthbertson
and Gasparro's
one.In particular,
specification
preferred
we
have
estimated
one.
The
fact
that
than
an estimated
coefficient
greater
in excessof one can be viewedas due to our widersample
coefficients
Our resultsare consistent
estimatedstatistics.
and hencemoreefficient
withJones(1995),who reportsevidenceofincreasing
investment/output
in thepostwarperiod,andDavisand
countries
ratiosfortheindustrialized
ratiointhemajor
Madsen(2001) ,whonotea sharpriseinthecapital/output
Itmayalsobe linkedtoan increaseinthedepreciation
countries.
industrial
rate(wherethebasicmodelassumesa constantrate)and increasedcapital
moresensitive.
whichhasmadefixedinvestment
mobility
on Investment
5.2 Impactof Uncertainty
on investment.
effects
ofuncertainty
Weturnnowtoestimation
Developing
and shorttheestimated
from(13), Table3 presents
long-runcoefficients

13 The Hausman teststatistic

suggestspoolabilitywhen we incorporateonly business out=
put and Tobin's Q in our long-run specificationwith a test statisticof 0.20 (p-value
between
differentiate
difficult
to
it
is
often
et
al.
Pesaran
out
As
(1999)
0.90).
by
pointed
panel specificationson the basis of this test unlike the more stringentLikelihood Ratio
We hence employ Totest.Indeed the MG coefficienton Tobin's Q is alwaysinsignificant.
on
bin's Q only as a variantto check robustness.The instabilityof the estimatedcoefficient
Tobhs Q when output is excluded fromthe specification,and low likelihood,may well be
due to different
trendingcomponentsin investmentand Q.

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Reviewof WorldEconomics2005,Vol 141 (1)

18

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Byrne/Davis:Investmentand Uncertaintyin the G 7

19

runerrorcorrection
termfrom(14):
In(IB)it= 4>i(In (IB)ut-i- % - 1In(YB)it- ftCVOir)
In(B)ifH
+ SjiAIn(ffl)if
t . + cpjiA
7=1

;=0

(14)

+ y;ACVC),-,H
+ e/r.
7=0

Thelong-run
elasticities
on outputarealwayssignificant
andtheestimated
coefficients
areagainslightly
Also,theerror
largerthanone in magnitude.
reversion
to a long-run
correction
mean
termsare significant,
suggesting
we
find
fortheentire
In
measures
of
terms
of
the
volatility,
relationship.
of
and
real
rateunexchange
sampleperiodthatonlythemeasures nominal
across
ininfluencing
businessinvestment
aresignificant
certainty
long-run
and
-0.09
of
-8.02
theG7 witha PMG estimated
respectively
elasticity
of thevolatility
(notethatthelatteris scaledby 100 to aid convergence
are actuallycomparablein magnitude).Of the
so the effects
estimates,
varianceofeqothermeasuresshownin Table3, namelytheconditional
and
of inflation,
industrial
CV(DJP),
CV(DQ),
production,
uityprices,
of
these
effect
from
a
there
is
often
variables,
CV(DP),
uncertainty
negative
across
that
this
is
we
find
evidence
do
not
statistically
significant
although
theG7.
valuesassociatedwiththe HausmantestalwaysacThe probability
of equivalenceof PMG and MG and henceimnull
the
hypothesis
cept
acrosstheG7 as a whole.This
that
there
is
homogeneity
parameter
ply
forthe
is also trueforequityprices,industrial
productionand inflation
we cannotacceptparameter
LikelihoodRatiotests.However,
homogeneinterest
rate,nominaland
ityat 95 per centforthistestforlong-term
is
rate
real exchange
uncertainty,
althoughpoolability close to acceptinterestrateand the real exchangerate.Given
ance forthe long-term
we purthegreatercredencewe attachto the LikelihoodRatiostatistic,
our
of theexchangerateresultsby splitting
sue theissueof poolability
exand
real
nominal
the
for
combination
One
possiblepoolable
sample.
obtained
combe
can
by
changerate,accordingto theJoint' statistic,
this
instance
In
and
UK
the
France,
4).
(Table
Italy
Germany,
bining
to -11.81
increasesas does the significance,
coefficient
the uncertainty
= 3.31) forthenominalrateand -0.13 (3.23) fortherealrate.
(t-statistic
relationto theequilibrium
Wealso finda greater
speedofmeanreversion
ship.

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ReviewofWorldEconomics2005,Vol. 141 (1)

20

and ExchangeRate Sub Samples

Table 4: PMGE Investment
PMGE

MGE

PMGE

MGE

Individual
coefficients

xIrU

rate
Nominalexchange
1.346
(t= 24.944)
-8.018
CV(DER)
G7
(-2.887)
CV(DER)
EU4
Errorcorrection -0.077
(-5.270)
ln(YB)

coefficients
Joint
xlR{.}

1.439
(11.637)
-25.198
(-2.097)
-0.083
(-4.431)

1.233
(21.371)
-11.808
(-3.312)
-0.094
(-3.855)

30.72{12}
[0.00]
3.44(12}
[0.18]

1.202
(63.534)

0.221{3}
[p = 0.97]

-12.670
(-2.852)
-0.097
(-4.578)

3.826{3}
[0.28]

4.19 {6)
[0.65]
n.a.

Realexchange
rate
ln(YB)
CV(DRER)
G7
CV(DRER)
EU4
Errorcorrection
coefficients
Joint
XlrD
XtfU

1.371
(24.720)
-0.094
(-2.780)
-0.078
(-5.661)

1.439
(14.851)
-0.256
(-1.547)
-0.081
(-4.429)

30.41 {12}
[0.00]
2-!8 {12}
[0.34]

1.265
(21.711)
-0.134
(-3.232)
n.a.{

1.253
(35.919)

0.868{3}
[p = 0.83]

-0.136
(-3.522)
n.a4

2.132(3}
[0.55]

3.343{6}
[0.76]
n.a.

Note:Estimated
coefficients
at the5 percentlevelinbold.EU4 consists
ofFrance,
significant
Germany,
Italyand theUK. See also Tables2 and 3. $ Thisis due to a problemwithan
Italiandynamiclag lengthgreater
thanone. Reducingthemaximumlag lengthto one,reducedthepooledcoefficient
on volatility
to -0.142 withoutchanging
theindividual
counerrorcorrection
termfor
tryresultsforthe othercountriesand producinga significant
PMGE. t-statistics
in parentheses,
p-valuesin squarebrackets[]. Sampleperiod1973:11996:4.xlR{.) denotestheLikelihood
Ratiostatistic.
^{.} is theHausmantest.

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in theG7
Investment
and Uncertainty
Byrne/Davis:

21

5.3 Sensitivity
Analysis
to exTo assesstherobustness
ofour results,
we consideredit important
aminethestability
ofourestimates
acrosstime.We do so bysplitting
our
inhalf,andalso
thedataroughly
sampleperiodintheearly1980s,dividing
theuncertainty
coefficient
recursively.
estimating
Bythesemeans,we can
ofexchangeratevolatility
has increased
examinewhether
theimportance
have
othertypesofvolatility
overtime,or indeedwhether
or diminished
entire
in
results
for
the
are
obscured
estimation
effects
which
important
sample.
thetimeseriesspan intotwo sub-samples
The resultsfromsplitting
(Tables5 and 6) showthatin theearliersampleperiod,1973:1-1983:4,
at the10
on investment
effect
ratevolatility
onlyhasa significant
exchange
=
is
-5.16
the
estimated
coefficient
cent
level;
(t-statistic
per
significance
- 1.80). However,
fromthenominaleffective
forthelaterperiodtheeffect
and significance
inbothmagnitude
rateincreases
(thecoefficient
exchange
= 2.42). Therearesimilarincreasesin thereal
becomes-41.59, t-statistic
areclosertoonein
Wenotealsothattheoutputcoefficients
ratecoefficient.
rates.
interest
thelatersample,in thecaseofexchangeratesandlong-term
are
confirmed
ratevolatility
on theimpactofexchange
Theseresults
bythe
coefficients
estimated
(and standarderrorbands)in FigureI.14
recursively
we seeexchangeratevolatility
Fromthefigures
becomingmoreimportant
morerecentdataintooursampleperiod.Forsomeof
whenweincorporate
coefficient.
theearlier
negative
periodstheredoesnotappeartobe a strongly
belowzero
decreasesfurther
Butas we moveintothe1990sthecoefficient
a
of
factor
two).
by
(approximately
In thelatterperiod,hedgingwasmorecommon.Thismaybe balanced
finance
forinvestment
as opposedtointernal
on external
reliance
bygreater
imtheorem
in thelaterperiod(althoughnotethattheModigliani-Miller
andpossiblygreater
capitalmobility.
pliesthatthisshouldbe "irrelevant")
to
sensitive
firms
are
less
that
be
Another
exchangerates
may
explanation
In
the
secondhalfof
of
whentheyareina situation imperfect
competition.
removal
antitrust
thesample,financial
liberalization,
policy,privatization,
and otherformsofmarket
oftradebarriers
openinghavebeenmuchmore
Therehasalsobeenan increaseintherangeofgoodsand services
marked.
increasedcontestability
whicharetraded.The resulting
mayunderliethe
andgrowing
coefficient
impactofuncertainty.
shifting
14 We believeour
for
of PMGE is highlyappropriate
estimation
approachto recursive
in a paneldata study.
of coefficients
thestability
testing

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22

Review of World Economics 2005, Vol. 141 (1)

"*

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24

ReviewofWorldEconomics2005,Vol. 141 (1)

Figure1: The Long-RunRecursivePMGE Coefficient

forExchangeRate Uncertainty
a. NominalExchange
Rate

n - B- L-M^r"^ ^^-^^L-

' '

-10 - A- --"

+^^'^

-15
1985

1987

1989

1991

'..

-20 J
1983

1993

|1

1995

b. RealExchange
Rate

0.05

o.o - *^"
-0.1 -^

A A

'

^^_
A

^^

'-

>*<m

'-

'-

^*

*-*

-0.15

'-

--

-0.2

^-ir

-0.25 -

1983
--

1985

1987

LRCoeff. -*-

1989

1991

+1.96 S.E.

1993

1995

'

-1.96 S.E.

There is evidenceof cross-sectionalhomogeneityof thelong-runcoefficientsforthelaterperiod usingboth thetestswhenwe incorporatenominal exchangerate volatilityinto our specification(Table 5, Time Split 2,
Columns 2 and 3). The industrializedcountries'macroeconomicstructures
with respectto investment,openness and the exchangeratevolatilityare,
thisresultsuggests,becomingincreasingly
similar.This mayagain be linked
to increasedproductmarketliberalization,capitalmobility,
increasedopenness and marketefficiency.

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in theG7
and Uncertainty
Investment
Byrne/Davis:

25

The G7 resultsforthevolatility
ofindustrial
production
givesus some
in theearlierperiodthatthereis a significant
on
indication
positiveeffect
in thelong run.However,we discountthisresultheresince
investment
is onlymarginally
theerrorcorrectheestimatedcoefficient
significant,
theabsence
tiontermis insignificant
at the 5 per centlevel(suggesting
and uncertainty)
withno
betweeninvestment
ofa long-runrelationship
RatioorHausmanstatisfromeithertheLikelihood
evidenceofpoolability
tic.
in
coefficient
Withregardto thelong-runinterest
rate,theestimated
at the5 percentleveland negative(-0.23).
thelaterperiodis significant
errorcorhave
a
reasonable
we
specification
(e.g. a significant
Although
is rejectedusingtheLikelihoodRatiotest
rectionterm),panelpoolability
Hausmantest.Conseand onlyacceptedwiththeless stringent
statistic,
it is possibleto splitthecross-section
quentlywe againconsiderwhether
withregard
and
6.
in
Table
Germany Italyappeartobehavesimilarly
sample
Ratio
Likelihood
the
This
is
shown
rate
interest
to long-run
by
volatility.
these
combine
we
whichis insignificant
statistic,
bya largemarginwhen
sinceItalyis typically
Our resultsaresomewhatsurprising
twocountries.
withregardtoEMU,seeforexample
as an economic"outsider"
considered
theevidencefromDarbyet al. (1999). In thisinstanceitis clearlyexhibitingsimilarbehaviourto thelargestEuropeaneconomy.We do not find
forFrance
and poolability
suchclearevidenceforcombinedsignificance
rates.But if
interest
oflong-term
or theUK withregardto thevolatility
theevidencesideswiththeUK exhibiting
(i.e.compared
relatively
anything
The LikelihoodRatio
to France)similarbehaviourto Italyand Germany.
is
at the5 percentleveland uncertainty
is borderline
statistic
significant
of-0.45.
witha coefficient
effect,
havinga negative
in the
on investment
of
the
calibrate
to
We seek
impact uncertainty
in
shown
are
These
above.
resultshighlighted
contextof the successful
rate
Table7. It can be seenthata 10 percentrisein thelevelofexchange
to theaverageleadsto a fallin
relative
ratevolatility
interest
or long-term
ofthelaterperiodexchange
case
the
in
cent
1-1.5
of
investment
except
per
ratefortheG7 in
interest
the
ratecoefficient
long-term
(5 percent)and
as
thelatersample(0.7 percent).Usingthestandarddeviationofvolatility
leadsto
a 1 standarddeviationrisein conditional
a benchmark,
volatility
rate
G7
full
the
for
investment
in
fall
cent
a 2-4 per
sample exchange and
thecase oftheEU exchange
In
estimates.
rate
interest
boththelong-term
is 7 percent,and 20 percentfortheG7 exchangeratein the
ratetheeffect
latersample.

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26

Review of World Economics 2005, Vol. 141 (1)

onInvestment
Table7: TheEconomic
ImpactofUncertainty
Sample

Variable

1973-1996

G7 nominal
exchangerate
EU4 nominal
exchangerate
G7 real
exchangerate
EU real
exchangerate
G7 nominalrate
exchange
G7 long-term
interest
rate
EU3 long-term
rate
interest

1973-1996
1973-1996
1973-1996
1984-1996
1984-1996
1984-1996

Average Coefficient Base

level
levelof CV

10 per
centrise

1 std
dev

50 per
centrise

0.013

-8.018

-0.107

-0.011

-0.037

-0.054

0.012

-11.800

-0.146

-0.015

-0.070

-0.073

1.41

-0.094

-0.133

-0.013

-0.035

-0.066

1.27

-0.134

-0.171

-0.017

-0.064

-0.085

0.013

-41.600

-0.534

-0.053

-0.202

-0.267

0.311

-0.227

-0.074

-0.007

-0.021

-0.037

0.298

-0.452

-0.144

-0.014

-0.035

-0.072

variance(CV) over
timestheaveragelevelof conditional
Note:Base levelis equal to thecoefficient
the sample.Since the investment
functionis specifiedin logs,0.01 is equivalentto a 1 per cent
change.

to testtherobustness
ofthe
Twofurther
wereundertaken
experiments
mainresults.
we
Tobin's
to
the
same
First, introduced
Q
equations,
following
and Gasparro(1995) and also to testtheempirical
of
Cuthbertson
finding
and
Whited
that
be
irrelevant
in
the
(1996)
Leahy
uncertainty
proxiesmay
thatexclusionofQ led to omittedvariables
presenceofQ- or conversely
bias. Broadlyspeaking,theresults(Table 8) do not controvert
our main
at around0.16in all ofthePMG estimates.
When
Q is significant
findings.
Tobin's
the
nominal
and
real
effective
rates
remain
Q,
including
exchange
in thePMG estimates.
We can onlyacceptpoolability
withthe
significant
Hausmantest,however.
we
time
removed
from
means
the
variables
Second,
in thepanelas a meansofaccounting
forresidualcorrelation
acrosscrosssections15
but thisagaindoes littleto the results.16
Third,in Byrneand
Davis (2002) we reportedPMG resultsforthe Kenenand Rodrickand
Resultsarestatistically
rollingstandarddeviationmeasuresofuncertainty.
weakerand economically
lessplausiblethanforGARCH,17thuslending
15
Technically,this deals with common unobservedglobal factorswhich have the same effecton individual countries,as may have occurred in the 1979 oil crisisfor example.
Resultsare available upon request.
The PMG estimatesusing these moving-averagemeasuresof exchangerate volatilitydid
not provide resultsin favourof a negativeeffectfrom exchange rate volatilityon invest-

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Byrne/Davis:Investmentand Uncertaintyin the G 7

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28

ReviewofWorldEconomics2005,Vol. 141 (1)

we havepresented
in favourof the
supportto thetheoretical
arguments
ofGARCHas a measureofuncertainty.
superiority
6 Conclusions
on investment
anduncertotheempirical
literature
Thispapercontributes
and
a
of
sources
of
full
uncertainty implementing
tainty
byassessing
range
across
fordifferences
evidencefromPMGE. We can thustestexplicitly
and timeseriesevidence
countriesand benefitfromboth cross-section
Our
and uncertainty.
betweeninvestment
whentestingthe relationship
is
on
the
ARDL
that
it
based
additional
benefit
has
the
appanelapproach
We
of7(1) and1(0) regressors.
proachwhichis robusttotheincorporation
on
an
is improvement
a GARCHmethodology
also suggestthatutilizing
as thelattermayonlymeasuresammovingaveragemeasuresofvolatility,
in
evidencepresented
The
than
rather
uncertainty. empirical
plevariability
is harmful
thatexchangerateuncertainty
thispapershowsunequivocally
Thereis evidence
bothfortheG7 and forall sub-samples.
to investment,
interest
of a growingexchangerateeffectoverthe sample.A long-term
otherthanFranceoverthe
also emergesformajorEU countries
rateeffect
a one standarddeviationrisein
1984-1996period.For mostestimates,
rates
interest
ofeffective
conditional
exchangeratesorlong-term
volatility
much
leadstoa 2-percentfallin investment
althoughsomesamplesgive
ofinflation,
for
Results
declines.
equitypricesand inuncertainty
greater
that
dustrialproductiondo not,in contrast,
suggest thesevariableshave
acrosstheG7.
investment
on
effect
a majorand consistently
negative
results
forEMU, thepanel
As regardstheimplications
suggestit is of
theUK, to reduceeffective
forall thelargeEU countries,
benefit
including
Sinceit is likelythat
rate
interest
and
rate
volatility.
long-term
exchange
rate
nominal
(where
EMU willreducetrade-weighted
exchange volatility
is
EMU
euro
the
with
area),
evenfortheUK, over50 percentoftradeis
does
Thiswillbe thecase as longas EMU
indicatedto favourinvestment.
inflation
rates),
ratevolatility
notboostrealexchange
(owingto differential
from
effect
of a negative
thereis someindication
ment.Of theothervariablesconsidered,
formonetary
of unconditional
The implications
policyreactionsmay
inflation.
volatility
that
volatility
be a reasonwhyit is movingaverageand notGARCHmeasuresof inflation
ratesand the equitypriceseries
interest
short-and long-term
come to thefore.Finally,
was poolability
In none of the estimates
accepted
providedlittleevidenceof anyeffect.
withtheLikelihoodRatiotest.

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and Uncertainty
in theG7
Investment
Byrne/Davis:

29

or lead to muchgreater
in theremaining
bilateralrates
volatility
floating
basketsofthe
(basicallytheyenand dollar)thatformthetrade-weighted
UK andotherlargeEU countries.
Neither
oftheseseemsverylikely.
Equally,
forsomecountries
EMU mayalso reducelong-term
interest
ratevolatility
lowerfiscal
(given,forexample,a deeperand moreliquidbond market,
deficits
and lessvolatileshortrates).Thiswouldcompoundthebeneficial
effect.
References
ReEconomic
American
underUncertainty.
Abel,A. (1983). OptimalInvestment
view73 (1): 228-233.
and R. S. Pindyck(1996). Options,theValueof
Abel,., A. Dixit,J.C. Eberly,
111 (3): 753-777.
Journal
Quarterly
ofEconomics
Capitaland Investment.
P.,and E. P. Davis (2001). Some Evidenceon FinancialFactorsin the
Ashworth,
NIESR
fortheG7 Countries.
BusinessInvestment
ofAggregate
Determination
of Economicand Social Research,
DiscussionPaper 187. NationalInstitute
London.
in theUK.
Investment
ModelofManufacturing
Bean,C. (1981).An Econometric
106-121.
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