The Impact of Short- and Long-run Exchange Rate Uncertainty on Investment: A Panel Study of Industrial Countries

We examine the relationship between aggregate investment and exchange rate uncertainty in the G7, using panel estimation and decomposition of volatility derived from the components generalized autoregressive conditionally heteroscedastic (GARCH) model. Our dynamic panel approach takes account of potential cross-sectional heterogeneity, which can lead to bias in estimation. We find that for a poolable subsample of European countries, it is the transitory and not the permanent component of volatility which adversely affects investment. To the extent that short-run uncertainty in the CGARCH model characterizes higher frequency shocks generated by volatile short-term capital flows, these are most deleterious for investment. Copyright 2005 Blackwell Publishing Ltd.