02 March 2018

Bank of England: Business investment, cost of capital and uncertainty in the United Kingdom — evidence from firm-level analysis

This paper presents firm-level analysis of factors that have driven business investment in the UK in the recent past, using a new dataset on different cost of capital and uncertainty measures. In general, authors find that macroeconomic fundamentals, cost of capital and uncertainty have all been important drivers of investment.

Their estimates of the elasticity of investment with respect to changes in the cost of capital are relatively low compared to previous literature, and for some cost measures they are not statistically significant. In contrast, their main measure of firm-level uncertainty (based on stock price volatility) is strongly significant, suggesting that firm-level uncertainty shocks have been important drivers of investment dynamics in the UK.

On the other hand, the cost of capital, while significant, seems to have a smaller impact on firms’ investment. However, their analysis shows that their preferred cost of capital measure had much more of an effect on investment before the financial crisis than after it, while the opposite is true for firmlevel uncertainty. These results could have significant policy implications, especially in the current uncertain post-EU referendum environment.

Although author‘s dataset is too small for wide-ranging aggregate-level conclusions to be drawn, it does appear possible that macroeconomic policies helping to alleviate investment uncertainty could have more traction than previously appreciated. At the same time, firms’ investment decisions may be reacting more sluggishly to traditional monetary policy measures than theory and historical estimates suggest.

Their analysis necessarily comes with caveats and suggestions for further research. The data required for the analysis, especially one that is based on firm-level measures of the cost of capital and uncertainty, means that the sample authors use is relatively small. However, they show that there is substantial variation at the firm level that is important for understanding investment patterns. Enhancing data availability and expanding firm-level surveys on investment is clearly a key area of further practical development. Investigating the plausibility of alternative models of business investment that can explicitly incorporate the non-convex adjustment costs that will matter for short-run dynamics, while being tractable enough to estimate with firm-level data, is another important avenue of further work.  

Working paper

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