Policy Uncertainty and Long-Run Investment and Output across Countries

I explore how and and to what extent policy uncertainty can account for the observed long-run cross-country differences in capital price and levels of aggregate investment and output. I present a model economy where the industry-level policy-related investment cost is uncertain. Holding the average one-period investment cost constant, policy uncertainty leads to a higher capital price and subsequently to lower levels of long-run aggregate investment and output. Policy uncertainty also makes industry-level investment more volatile. In an investigation of industry-level investment across countries, I find that, consistent with the model, industry-level investment in lower-income countries is more volatile. I calibrate the model so that the simulated investment sequences from the model mimic the actual investment sequences. I find that policy uncertainty can account for large differences in long-run capital price, investment, and output across countries. Between the lowest-income and the highest-income countries, policy uncertainty can account for the capital price difference by a factor of about three, and can account for investment and output level differences of a similar magnitude.