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Financing Constraints, Irreversibility, and Investment Dynamics

Author

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  • Andrea Caggese

Abstract

We develop a structural model of an industry with many entrepreneurial firms in order to investigate the cyclical behaviour of aggregate fixed investment, variable capital investment and output. In particular, we consider an environment in which the entrepreneur cannot borrow unless the debt is secured by collateral and cannot sell fixed capital without liquidating her whole business. We show that, when these entrepreneurs experience persistent idiosyncratic and aggregate shocks, the inter-play between financing constraints and irreversibility of fixed capital is essential to explain several common observations. It helps to explain why inventory investment is very volatile and procyclical, especially during recessions, and why the output and inventories of small firms are more volatile and more cyclical than that of large firms. The model is also consistent with the observations that inventory investment leads the business cycle, and that both fixed and inventory investment are sensitive to the net worth of firms, even when marginal productivity of capital is taken into account.

Suggested Citation

  • Andrea Caggese, 2003. "Financing Constraints, Irreversibility, and Investment Dynamics," FMG Discussion Papers dp440, Financial Markets Group.
    • Handle: RePEc:fmg:fmgdps:dp440
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    Citations

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    Cited by:

    1. Peter N. Gal & Gabor Pinter, 2017. "Capital over the Business Cycle: Renting versus Ownership," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 49(6), pages 1299-1338, September.
    2. Amable, Bruno & Chatelain, Jean-Bernard & Ralf, Kirsten, 2010. "Patents as collateral," Journal of Economic Dynamics and Control, Elsevier, vol. 34(6), pages 1092-1104, June.
    3. Charles A.E. Goodhart & Dimitrios P. Tsomocos & Xuan Wang, 2023. "Support for small businesses amid COVID‐19," Economica, London School of Economics and Political Science, vol. 90(358), pages 612-652, April.
    4. Julia K. Thomas & Aubhik Khan, 2009. "Collateral constraints, capital specificity and the distribution of production: the role of real and financial frictions in aggregate fluctuations," 2009 Meeting Papers 1133, Society for Economic Dynamics.
    5. Caggese, Andrea, 2007. "Testing financing constraints on firm investment using variable capital," Journal of Financial Economics, Elsevier, vol. 86(3), pages 683-723, December.
    6. Kaido Kepp & Kadri Männasoo, 2021. "Investment irreversibility and cyclical adversity: Implications for the financial performance of European manufacturing companies," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 42(7), pages 1665-1678, October.
    7. Alessandro Villa, 2022. "Credit Misallocation and Macro Dynamics with Oligopolistic Financial Intermediaries," Working Paper Series WP 2022-41, Federal Reserve Bank of Chicago.
    8. Julia Thomas & Aubhik Khan, 2012. "Uncertainty Shocks in an Economy with Collateral Constraints," 2012 Meeting Papers 1075, Society for Economic Dynamics.
    9. Aubhik Khan & Julia K. Thomas, 2013. "Credit Shocks and Aggregate Fluctuations in an Economy with Production Heterogeneity," Journal of Political Economy, University of Chicago Press, vol. 121(6), pages 1055-1107.
    10. Björn A. Hauksson, 2005. "Aggregate business fixed investment," Economics wp27_bjorn, Department of Economics, Central bank of Iceland.
    11. repec:ebl:ecbull:v:5:y:2007:i:10:p:1-10 is not listed on IDEAS
    12. Cao, Shutao & Leung, Danny, 2020. "Credit constraints and productivity of SMEs: Evidence from Canada," Economic Modelling, Elsevier, vol. 88(C), pages 163-180.
    13. McGee, M. Kevin, 2010. "Twice constrained investment under uncertainty: A mixed time model," Research in Economics, Elsevier, vol. 64(2), pages 110-120, June.
    14. Richard Holt, 2007. "Investment, irreversibility and financial imperfections: the rush to invest and the option to wait," Economics Bulletin, AccessEcon, vol. 5(10), pages 1-10.
    15. Simona Mateut & Paul Mizen & Ydriss Ziane, 2012. "No Going Back: How the Production Process Affects Access to Short-term Credit," Discussion Papers 12/14, University of Nottingham, Centre for Finance, Credit and Macroeconomics (CFCM).
    16. Shutao Cao & Danny Leung, 2016. "Financial Constraint and Productivity: Evidence from Canadian SMEs," Staff Working Papers 16-44, Bank of Canada.
    17. Rainer Niemann & Caren Sureth, 2011. "The Impact of Differential Capital Income Taxation on the Value of Risky Projects," Economics Bulletin, AccessEcon, vol. 31(2), pages 1047-1054.
    18. Alessandra Guariglia & John Tsoukalas & Serafeim Tsoukas, 2010. "Investment, irreversibility, and financing constraints in transition economies," Discussion Papers 10/03, University of Nottingham, School of Economics.
    19. Shi, Yang & Li, Jiachen & Liu, Ruiming, 2023. "Financing constraints and share pledges: Evidence from the share pledge reform in China," Journal of Corporate Finance, Elsevier, vol. 78(C).
    20. Sarte, Pierre-Daniel & Schwartzman, Felipe & Lubik, Thomas A., 2015. "What inventory behavior tells us about how business cycles have changed," Journal of Monetary Economics, Elsevier, vol. 76(C), pages 264-283.
    21. Kaoru Hosono & Masaki Hotei & Chie Umezaki, 2013. "External Finance Constraints and the Timing of Investment Spikes," Public Policy Review, Policy Research Institute, Ministry of Finance Japan, vol. 9(2), pages 365-404, March.
    22. Michael Siemer, 2014. "Firm Entry and Employment Dynamics in the Great Recession," Finance and Economics Discussion Series 2014-56, Board of Governors of the Federal Reserve System (U.S.).

    More about this item

    JEL classification:

    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies

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