Econometrica: Mar, 2016, Volume 84, Issue 2

Inefficient Investment Waves

https://doi.org/10.3982/ECTA11788
p. 735-780

Zhiguo He, Péter Kondor

We show that firms' individually optimal liquidity management results in socially inefficient boom‐and‐bust patterns. Financially constrained firms decide on the level of their liquid resources facing cash‐flow shocks and time‐varying investment opportunities. Firms' liquidity management decisions generate simultaneous waves in aggregate cash holdings and investment, even if technology remains constant. These investment waves are not constrained efficient in general, because the social and private value of liquidity differs. The resulting pecuniary externality affects incentives differentially depending on the state of the economy, and often overinvestment occurs during booms and underinvestment occurs during recessions. In general, policies intended to mitigate underinvestment raise prices during recessions, making overinvestment during booms worse. However, a well‐designed price‐support policy will increase welfare in both booms and recessions.

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