This paper argues that precautionary savings due to uninsurable earnings uncertainty are likely to be an important source of aggregate wealth accumulation. The stylized model presented in this paper can easily generate levels of wealth above 60 percent of the observed net wealth in the United States, net of conventional life-cycle savings.

At the microeconomic level, durable purchases are often discontinuous and relatively large. This feature has the potential to explain why aggregate expenditure on durables responds only slowly (relative to the frictionless permanent income model) to wealth and other aggregate innovations. In this paper I develop new results on the problem of dynamic aggregation of stochastically heterogeneous units, which help to characterize the connection between microeconomic behavior and aggregate dynamics in the presence of nonconvex adjustment costs. Using these results and splitting postwar U.S. aggregate durable purchases into different subcategories and time periods, I provide further support for the view that lumpy microeconomic purchases play an important role in explaining the time-series behavior of aggregate expenditure on durable goods.

Recent contributions emphasize that the presence of exchange-rate target zones has important effects on the within-band behavior of exchange rates when agents are forward-looking. We find that the implications of available models are inconsistent with European exchange-rate data, and we suggest that the frequent realignments occurring in the period we consider may be responsible for this. We construct a model in which the likelihood of a realignment in the near future increases as the exchange rate approaches the limits of its fluctuation band and show that its implications are broadly consistent with the evidence.

We investigate industry response to cyclical variations in demand. Production units that embody the newest process and product innovations are continuously being created, and outdated units are being destroyed. Although outdated units are the most likely to turn unprofitable and be scrapped in a recession, they can be "insulated" from the fall in demand by a reduction in creation. The structure of adjustment costs plays a determinant role in the responsiveness of those two margins. The calibrated model matches the relative volatilities of the observed manufacturing job creation and destruction series, and their asymmetries over the cycle.

For more than a half a decade the fact that expenditure on durables can be well approximated by a random walk has remained a hidden puzzle, challenging almost any theory in which agents smooth the use of their wealth. This paper shows that once a nonparsimonious approach is used, or lower frequencies of the data are examined, the fact itself disappears; changes in expenditures on durables reveal a degree of reversion consistent with the permanent income hypothesis (PIH), although this reversion occurs at a rate significantly slower than what is suggested by a frictionless PIH model.

The response of most stock variables (e.g., capital, housing, consumer durables, and prices) to exogenous impulses involves a dynamic-or 'short-run' - reaction, and a target - or 'long-run' - reaction. The difference between these two is typically attributed to some form of adjustment cost. In this paper I argue that the small sample problems of cointegrating procedures used to estimate the ' long'-run component are particularly severe when adjustment costs are important. More precisely, elasticity estimates will tend to be biased downward. I illustrate the empirical relevance of this by showing that the target elasticity of capital with respect to its cost is - severely downward biased when estimated with conventional OLS cointegration procedures. Once this is corrected, the elasticity of the U.S. capital-output ratio to the cost of capital is found to be large and close to (minus) one.

In spite of significant institutional and macroeconomic reforms over the last decade or two, capital flows to developing economies remain highly volatile. In 1996, net private capital flows to emerging markets reached US$230 billion; by 1997 these flows had been cut in half; by 1998 halved again; and after a mild recovery during 1999, flows fell in 2000 and 2001 to slightly over one-tenth the level of 1996. With the exception of developing Asia, 2002 does not look much rosier (see International Monetary Fund, 2002 p. 12 [table 1.3]). The economic, political, and social costs of these large swings in capital flows are enormous. The most vivid examples are seen in the economies that experience deep crises, including (since 1997) Thailand, Indonesia, Malaysia, Korea, Russia, Brazil, Turkey, and Argentina. While in many instances there are important domestic deficiencies behind these reversals, there is also a well-founded sense that international financial markets often exacerbate the problem. It is not surprising, then, that as with the debt crisis of the early 1980’s and the Mexican crisis of the 1990’s this new wave of crises has led to innumerable calls for deep reform to these markets. Nowhere is this more apparent than in the design of new “rules of engagement” for the International Monetary Fund. The important work of multiple official and unofficial commissions, leveraged by its own rethinking, promises to transform this institution from the ground up. In a nutshell, most experts agree that the International Monetary Fund should be much more focused, transparent, predictable, and quick in its interventions, and its role limited to surveillance (pre-crisis) and lenderof-last-resort/bankruptcy-court (during crises) activities. This seems right. I believe, however, that by focusing almost exclusively on the needs of countries undergoing deep crises (highly illiquid and “bankrupt” economies) these reform proposals have left unaddressed a significant fraction of the costs associated with capital-flows reversals. An important share of these costs are borne by countries that experience deep contractions but do not undergo full-blown crises, and much of the cost experienced by those countries that do fall into deep crises is experienced well before the open crisis phase develops. Often, the latter is just the final stage of a prolonged and politically thorny economic period of sharply reduced access to international capital markets. Surely, the anticipation of more orderly resolution and access to a few credit lines, should the open crisis phase arrive, would (by backward induction) eliminate some of the costs that precede these events as well. But this benefit is indirect only and relies on a chain of reasoning that requires more rationality and trust in the new system † Discussants: Stanley Fischer, Citigroup; Allan Meltzer, Carnegie Mellon University; Jeffrey Sachs, Columbia University; Nicholas Stern, World Bank.

Understanding the effects of uncertainty over any decision variable has fascinated economists for a long time. Risk aversion and incomplete markets are likely to make the investment-uncertainty relationship negative (e.g., Roger Craine, 1989; Joseph Zeira, 1989). What happens in the absence of risk aversion and incomplete markets is, however, ambiguous. Richard Hartman (1972) and Andrew B. Abel (1983, 1984, 1985) found that in the presence of (symmetric) convex costs of adjustment, mean-preserving increases in price uncertainty raise investment of a competitive firm as long as the profit function is convex in prices. On the other hand, the recent literature on irreversible investment (e.g., Robert S. Pindyck, 1988; Giuseppe Bertola, 1988) has shown that increases in uncertainty lower investment. All these results have been derived under either risk neutrality or complete markets.' Intuition suggests that the explanation for such a difference lies with the asymmetric nature of adjustment costs in the irreversible-investment case, as compared with the symmetry of the adjustment-cost mechanisms proposed by Abel and Hartman. Although this intuition is confirmed in this paper, asymmetric adjustment costs are shown not to be sufficient to explain why the results differ. In fact, a more hidden but at least as important difference between these two literatures is that the former assumes perfect competition and constant returns to scale, whereas the latter assumes either imperfect competition or decreasing returns to scale (or both).2 The purpose of this paper is to highlight the role of the decreasing marginal return to capital assumption (due to either imperfect competition or decreasing returns to scale [or both]) in determining the effects of adjustment-cost asymmetries on the sign of the response of investment to changes in uncertainty (under risk neutrality). For this, the paper develops a simple model with a cost-of-adjustment mechanism general enough to consider both symmetric-convexity and irreversibility as special cases. One of the most important findings is the lack of robustness of the negative relationship between investment and uncertainty under asymmetric adjustment costs3 to changes in the degree of competition. In fact, when firms are nearly competitive, the conclusion of Hartman and of Abel holds no matter how asymmetric adjustment costs are. Studying adjustment-cost mechanisms has a central role in understanding the dynamics of investment and its business-cycle implications, but conclusive results about the sign of the instantaneous relationship between uncertainty and investment should not be *Department of Economics, Columbia University, New York, NY 10027. I am grateful to Giuseppe Bertola, Prajit Dutta, Glen Hubbard, Anil Kashyap, Richard Lyons, and the referees for their useful comments. 1The financial literature on investment has considered risk aversion through a premium in the discount rate determined by the CAPM, (capital asset pricing model), intertemporal CAPM, or consumption CAPM. However, often this discount rate is left unchanged when studying the response of investment to uncertainty changes (e.g., Pindyck, 1988 pp. 974-5), thereby omitting the effect of changes in uncertainty on investment due to risk aversion (and incomplete markets). 2In the typical version of the irreversible-investment problem, there is no cost of upward adjustments; thus, imperfect competition and (or) decreasing returns to scale are required to bound the size of the firm. 3In this paper, asymmetric adjustment cost refers to the case in which it is more expensive to adjust downward than upward. Certainly, the opposite case is a trivial extension of the case studied in this paper.