Though much research has been done worldwide, the effect of uncertainty concealed in inflation expectations on private investment is disputed theoretically in the absence of enough empirical evidence to reach a conclusion. Furthermore, at the same time, traditional investment equations do not reflect the structural correlation between investment and product, because they ignore the rational expectations theory. This paper presents a theoretical foundation and an empirical estimation of private investment in Israel, using Israel's unique data regarding inflation expectations. The results support the hypothesis that uncertainty negatively affects private investment in Israel. Furthermore, it appears that uncertainty is the most important factor, next to product, affecting private investment.

During the 1960s, theoretical researchers became interested in the effect of uncertainty on demand. Hartman (1972) showed that when adjustment costs (for change in output) and profit functions are convex to prices, uncertainty in output prices and wages will positively affect investment. Abel (1983) maintained, using the same assumptions, that uncertainty in prices will, under perfect competition, increase the investment of firms indifferent to risks.

Conversely, Pindyck (1988) showed that the increase in prices uncertainty will, under perfect competition, decrease (irreversible) investments of firms indifferent to risks. In a later research, Pindyck (1993) showed that there is an alternative cost to present investment, similar to the exercise of a call option, which increases with uncertainty. Caballero (1991) showed that the difference in various models stems from the asymmetry of adjustment costs in some models that show negative effects versus symmetry in other models and differences in the assumptions of imperfect or perfect competition and of decreasing or fixed returns. In this light, he concluded that negative effects are more frequent than positive effects.

Ferderer (1993a) raises the possibility that uncertainty negatively affects investment due to its negative effect on credit liquidity, clarity of price indications, or risk premiums embodied in interest rates. Caballero and Pindyck (1996) showed that the effect of uncertainty is more negative at the sectoral level (as compared to the firm level), given the symmetry of adjustment costs, because of the asymmetry in entrance and exit of competitors under conditions of agitation in demand. Abel et al. (1996) claimed that parallel to the call options, there is also a put option of investing in the present and selling in the future, whose value increases as the motif of irreversibility of investment is less perfect, and uncertainty intensifies. Therefore, in an environment of uncertainty, two contradictory options act on the investment whose values increase with uncertainty and their pure effect cannot be determined theoretically a priori.

Monetary Economics Journal, Inflation Expectations, Private Investments, Traditional Investment Equations, Neoclassical Model, Technological Limitation, Capital Services, Gross Investments, Rational Expectation Theory, Gross Domestic Product, Augmented Dickey-Fuller Test, Elastic Acceleration Model, Error Correction Model, Monetary Policy.