Uncertainty, Investment and Firm Dynamics

Chapter 1: Unpacking Economic Uncertainty: Measuring the Firm, Sector and Aggregate Components Existing measures of uncertainty are typically estimated in a preliminary step using market data (Bloom, Bond and Van Reenen, 2007), media sources (Baker, Bloom and Davis, 2016), or macroeconomic indicators (Jurado, Ludvigson and Ng, 2015), and then treated as if they were observable data series (Carriero, Clark and Marcellino, 2018). These measures often fail to capture the complexity and heterogeneity of firms’ salient uncertainty. While efforts have been made to create disaggregated uncertainty measures, much of the economic literature on the impact of uncertainty on firms’ decisions has focused on aggregated uncertainty, assuming a uniform uncertainty process across firms. To address this issue, this chapter raises two questions: “How is firm uncertainty decomposed into firm, sector, and aggregate sources? To what extent does heterogeneity of uncertainty exist across firms?” This chapter introduces a novel method to measure firms’ uncertainty, proxied by their sales volatility, and decomposes a multi-layered system of indices: commonalities among all firms (potentially driven by macro-level developments such as economic policy and aggregate demand shocks), sectoral commonalities (such as supply chain disruptions, technological shocks, and input price variations), and firm-specific factors. The approach used to measure uncertainty involves disaggregated firm-level data to construct different measures of uncertainty at aggregate, sectoral, and firm levels by decomposing the volatility of firms’ sales, termed “Overall Uncertainty” (OU). The chapter also contributes to the literature by introducing the concept of uncertainty heterogeneity and emphasises the differences in firms’ perceptions of uncertainty and its origins, as well as the varying impacts of uncertainty on different firms and sectors. The chapter validates this approach by demonstrating that the computed aggregate-level uncertainty for the U.S. economy aligns with existing measures of macroeconomic uncertainty, such as those by Baker, Bloom and Davis (2016) and Jurado, Ludvigson and Ng (2015). Using data from the Quarterly Compustat database, our results reveal significant heterogeneity in uncertainty across firms based on their characteristics and sectors. For example, larger firms tend to experience lower uncertainty than smaller firms. Moreover, high uncertainty episodes are more pronounced in the manufacturing sector compared to the services and mining sectors, corroborating findings on the sectoral heterogeneity of uncertainty by Born and Pfeifer (2021) and Parast and Subramanian (2021). These findings have significant implications for policymakers, particularly in understanding the vulnerability of smaller firms to macroeconomic conditions. The results underscore the need for fiscal and monetary policies that consider the differential impacts on firms’ uncertainty, which in turn affects their performance, investment decisions, and hiring choices. This understanding can empower policymakers to make informed decisions, aligning with empirical evidence on the stagnation of U.S. investments and industrial production over recent decades, especially in the manufacturing sector.