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Investment and the Real Interest Rate in Business Cycle Models

Author

Listed:
  • Virgiliu Midrigan

    (New York University)

  • Oleksiy Kryvtsov

    (Bank of Canada)

  • Chris Edmond

    (New York University)

Abstract

A pervasive prediction of business cycle models is that investment by firms in durable goods (capital, inventories) is highly sensitive to fluctuations in real interest rates (Thomas 2002, House 2007, Kryvtsov and Midrigan 2008). This prediction stands in sharp contrast with the data: investment is virtually insensitive to movements in interest rates. We ask: can an inventory-theoretic model of cash management by firms account for the low sensitivity of investment to interest rates in the data? In the model, a cash-in-advance constraint and frictions in the asset market lead firms to hold positive inventories of cash (low interest bearing liquid assets). These cash holdings disconnect the user cost of durable goods from the real interest rate and have the potential of reconciling the model's predictions with the data. We investigate this hypothesis by calibrating the model to account for patterns of cash holdings and investment in the Compustat firm-level data. We then study the model's aggregate implications.

Suggested Citation

  • Virgiliu Midrigan & Oleksiy Kryvtsov & Chris Edmond, 2009. "Investment and the Real Interest Rate in Business Cycle Models," 2009 Meeting Papers 862, Society for Economic Dynamics.
  • Handle: RePEc:red:sed009:862
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