The Effects of Regime-Switching Uncertainty on Irreversible Investment Decisions WPS/96-9

This paper focuses on how uncertainty about the sustainability of reform policies could affect the irreversible investment decisions of a tradable sector firm. Demand, costs and productivity are stochastic and are correlated with real exchange rate trends for the firm producing a tradable good. The firm's investment decisions are influenced by the variability of these business conditions processes, as well as by uncertainty about the timing of a large change in reform policies that dramatically alters the trend growth rates of these processes. Findings are that a firm that expects an unfavourable regime change is more hesitant to invest, reduces investment more in the face of ongoing variability of business conditions, and has a smaller investment response to favourable current trends. Ghana provides one example of a country where in the early stages of the Economic Recovery Program, entrepreneurs were uncertain about whether reform policies would be maintained.