Ebook On the Interaction of Financial Frictions and Fixed Capital Adjustment Cost Evidence from a Panel of German Firms
The aim of this paper is to understand the interaction of capital adjustment costs and financial frictions in determining investment activities of firms and thereby providing a better understanding of the nature of adjustment costs and financial frictions themselves. Both factors are central in determining investment, which itself is one of the key figures in determining the business cycle and in facilitating long term economic growth.
Up until very recently, most empirical studies concentrated on identifying either evidence for non-convexities of the adjustment technology for the stock of capital, or capital market frictions on investment. However, as Holt (2003) points out, in theory irreversibility and financial frictions should work as complements and have strong cross-effects. To put this result more generally, if there is more than one friction, the interaction of the multitude of frictions plays an important role and neglecting this interaction would lead to significant biases in empirical work.
Recently, Whited (2002) has analyzed the influence of financial constraints on the hazard rates of large investment projects and finds a well significant influence. Merz and Yashiv (2002) have studied the interaction of labor market frictions and adjustment cost. They find a significant cross effect, too, which at part explains measurement errors in the usual q-models of investment. In a companion paper to this one (Bayer, 2002), which analyzes a UK database, we find that neglecting the interaction of financial frictions and non-convexities and instead assuming linearity of the investment function leads to (severe) biases in the estimate of this function.
Besides the (econometric) issue of obtaining better estimates of the effect each friction has itself, combining financial frictions and non-convex adjustment costs for capital also has some economic appeal. It helps to explain seemingly contradictory observations, like a very low influence of finance on the stock of capital and simultaneously a strong influence on investment. Additionally it can pick up non-linearity in managerial decisions: As Whited (2002) argues, financial frictions are more likely to be taken into account by the management for large-scale projects than for maintenance.
However, any explanation of differences between short and long-run influences of liquidity on the stock of capital has to rely on a stock measure of liquidity rather than on flow-measures, which is more realistic anyhow as e.g. Blinder (1988) pointed out. Using a stock measure of liquidity like the equity-ratio can be problematic from an econometric perspective, yet no more problematic than using a flow-measure like cash-flow.
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