Investment and the Real Interest Rate in Business Cycle Models
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.
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