Macroeconomic conditions and a firm's investment decisions

We propose a model of a firm's reversible investment decision with macroeconomic conditions based on optimal switching of a diffusion regime. The switching costs and the cash flow generated from the firm depend on a business cycle alternating via a Markov chain, and the triggers of investment and disinvestment in each state are determined endogenously. Provided the investment costs are cyclical due to high wages and rents in a boom, the investment tends to be delayed in boom, while the disinvestment is likely to be made earlier in terms of the level of switching triggers. This result shows us that the 'hysteresis' of investment is a rigorous phenomenon that does not change dramatically depending on business cycle. Yet, the business cycle may still amplify and propagate the exogenous shocks from macroeconomic conditions as far as the persistence of business cycle is concerned. In particular, the investment is deferred and the disinvestment occurs earlier when recession lasts longer and boom ends soon. (C) 2014 Elsevier Inc. All rights reserved.