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The Finance-Uncertainty Multiplier

Author

Listed:
  • Xiaoji Lin

    (Ohio State University)

  • Nicholas Bloom

    (Stanford)

  • Ivan Alfaro

    (The Ohio State University)

Abstract
We show theoretically and empirically how real and financial frictions amplify the impact of uncertainty shocks on firms' investment, employment, debt (term structure of debt growth), and cash holding. We start by building a model with real and financial frictions, alongside uncertainty shocks, and show how adding financial frictions to the model roughly doubles the negative impact of uncertainty shocks on investment and hiring. The reason is higher uncertainty induces the standard negative real-options effects on the demand for capital and labor, but also leads firms to hoard cash and cut debt to hedge against future shocks, further reducing investment and hiring. We then test the model using a panel of US firms and a novel instrumentation strategy for uncertainty exploiting differential firm exposure to exchange rate and factor price volatility. We find that higher uncertainty reduces real investment and hiring, while also leading firms to increase cash holdings by cutting debt, dividends and stock-buy backs, and these effects are strongest in periods of higher financial frictions and for the most financially constrained firms. This highlights why in periods with greater financial frictions -- like during the global-financial-crisis -- uncertainty can be particularly damaging.

Suggested Citation

  • Xiaoji Lin & Nicholas Bloom & Ivan Alfaro, 2017. "The Finance-Uncertainty Multiplier," 2017 Meeting Papers 887, Society for Economic Dynamics.
    • Handle: RePEc:red:sed017:887
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