Variations in risk and fluctuations in demand: A theoretical model

Can variations in risk cause nonnegligible fluctuations in the flow of investment? This issue has so far only been studied in models with a fixed level of risk. Comparative statics may be inadequate, since risk varies over time. In this paper, a simple irreversible investment model is extended by including a stochastic process for the risk level. An increase in risk increases the value of waiting as in the standard model. The agent then allows larger deviations from the target level before adjusting, as long as the high-risk period continues. The new result is that this effect is stronger the shorter the high-risk periods are expected to be. Comparative statics may thus underestimate the effects of fluctuations in risk.