Series: Working Papers. 2546.
Author: Tatsuro Senga and Iacopo Varotto
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Abstract
Does micro-level investment irreversibility amplify or dampen business cycles? We show this depends on the source of aggregate risk. Investment irreversibility reduces fluctuations in both aggregate output and investment when firm-level idiosyncratic shocks aggregate up to economy-wide effects. This contrasts with models driven by aggregate productivity shocks, where irreversibility has little effect on volatility. The key is whether idiosyncratic shocks are suffi ciently volatile to cause the irreversibility constraint to bind cyclically for a significant mass of firms. If so, investment irreversibility hampers productivity-enhancing capital reallocation and reduces business cycle volatility. Moreover, household consumption smoothing is impeded when firms cannot adjust capital optimally, increasing real wage volatility. This labor market effect, combined with capital misallocation, reduces aggregate output volatility by 22 percent and investment volatility by 60 percent. These results highlight the importance of considering the source of economic volatility when assessing investment frictions. We provide empirical support for these predictions using firm-level investment data from Compustat.