The Real and Financial Impact of Uncertainty Shocks

We show theoretically and empirically how real and financial frictions amplify the impact of uncertainty shocks on firms’investment, employment, debt (term structure of debt growth), and cash holding. We start by building a model with real and financial frictions, alongside uncertainty shocks, and show how adding financial frictions to the model almost doubles the negative impact of uncertainty shocks on investment and hiring. The reason is higher uncertainty induces the standard negative real-options effects on the demand for capital and labor, but also leads firms to hoard cash and cut debt to hedge against future shocks, further reducing investment and hiring. We then test the model using a panel of US firms and a novel instrumentation strategy for uncertainty exploiting differential firm exposure to exchange rate and factor price volatility. We find that higher uncertainty significantly reduces real investment and hiring, while also leading firms to take a more cautious financial position by increasing cash holdings and cutting debt, dividends and stock-buy backs. This highlights not only the importance of financial frictions for amplifying the impact of uncertainty shocks, but how in periods with greater financial frictions — like during the global-financialcrisis —uncertainty can be particularly damaging. JEL classification: D22, E23, E44, G32