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Uncertainty and investment in private sector: An analytical argument and a review of the economy of Iran

Mellati, Ali (2008): Uncertainty and investment in private sector: An analytical argument and a review of the economy of Iran.

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Abstract

The initial theories of investment have emphasized the role of reduction of interest rate and increase in output for encouraging private investment. But there are ample grounds for doubting these theories. As a result, researchers have recently emphasized the importance of uncertainty in determining the private rate of investment. As different theories give various results with respect to their assumptions, a new theory of investment under uncertainty is explained in this study. Intuition is that investors use the best worst strategy instead of maximization of expected returns in an uncertain environment. There must be a time horizon within which entrepreneurs can rely on information and assess their projects. This time horizon is compared with adjusted payback period of projects. Projects with longer adjusted payback period will be rejected. Among the viable projects, a project with shorter adjusted payback period is preferable. The more is the uncertainty about the future, the shorter the horizon within which information can be trusted. Twenty-three factors relating to uncertainty are classified into three different categories: changes in policies and macroeconomic outcomes, the quality of public governance and socio- political institutions and conflicts. A panel data method is applied to examine the effect of these factors on the private investment rate. Among the macroeconomic factors, uncertainty relating to exchange rate distortion, terms of trade, growth and trade have significant negative effect on the private investment rate. The effect of other factors (i.e. uncertainty about credit to private sector, inflation and real interest rate) on the rate of private investment is insignificant. Among the socio-political institutions and conflict factors the negative effect of civil war, purges, coups and constitutional changes cannot be rejected. There is not enough evidence that other measures of socio-political uncertainty (i.e. democracy, revolutions, inequality, assassinations, strikes and riots) have a significant impact on the private investment rate. However I cannot reject the positive effect of war on the private investment rate. Among the indices of the quality of public governance, there is not enough evidence to reject the hypothesis that worsening condition of regulatory burden, rule of law and property rights will reduce the private investment rate. However, the hypothesis of negative effect of government contribution in economy on the private investment rate can be rejected. Surprisingly, the effect of control of corruption on the private investment rate is quite negative and significant.

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