Does price uncertainty really reduce private investment? A small model applied to Chile

Understanding how prices and quantities affect investment demand is important in analyzing adjustment policies in many developing countries. Recent literature emphasizes that uncertainty curtails private investment, adding a risk premium - the price of waiting. Several recent empirical studies have confirmed this result. This new development has been used to challenge one of the most popular policy recommendations derived from the traditional literature on investment: increasing investment by reducing the cost of capital through tax incentives or exchange rate policies. Because such policies are likely to increase uncertainty about the price of capital, their effect on private investment is ambiguous. The popular intuition is that private investors care more about the uncertainty of the price of capital than its level. In other words, incentives would have to be unreasonably high to bolster investments. The authors argue that uncertainty about the cost of capital should be compared with uncertainty about the price of output. Using a simple analytical model, they conclude that the efficiency of policies aimed at reducing the price of capital may be enhanced if: the volatility of the output price is greater than the volatility of the price of capital; and there is a positive correlation between changes in prices for output and capital. In both cases, private investment will be more responsive to changes in the price of capital (or in aggregate demand) because firms will minimize profit fluctuations. They apply this model to Chile for 1980-90. Chile is the reputed"success story"of structural adjustment and has achieved fairly stable growth in the past eight years. (The results correspond to the predictions of the analytical model.)