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Credit constraints, firms' precautionary investment and the business cycle

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    Abstract

    This paper studies the macroeconomic implications of firms' investment composition choices in the presence of credit constraints. Following a negative and persistent aggregate productivity shock, firms shift into short-term investments because they produce more pledgeable output and because they help alleviate future borrowing constraints. This produces a short-run dampening of the effects of the shock, at the expense of lower long-term investment and future output, relative to an economy with no credit market imperfections. The effects are exacerbated by a steepening of the term structure of interest rates that further encourages a shift towards short-term investments in the short-run. Small temporary shocks to the severity of financing frictions generate large and long-lasting effects on output through their impact on the composition of investment. A positive financial shock produces much stronger effects than an identical negative shock, while the responses to positive and negative shocks to aggregate productivity are roughly symmetric. Finally, the paper introduces a novel explanation for the countercyclicality of financing constraints of firms.

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    File URL: http://www.econ.upf.edu/docs/papers/downloads/1237.pdf
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    Bibliographic Info

    Paper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 1237.

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    Date of creation: Sep 2010
    Date of revision: Nov 2012
    Handle: RePEc:upf:upfgen:1237

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    Web page: http://www.econ.upf.edu/

    Related research

    Keywords: Investment composition; Financial frictions; Business cycles; Idiosyncratic production risk; Firm heterogeneity;

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