Ebook Investment dynamics with fixed capital adjustment cost and capital market imperfections
Economists’ knowledge of micro-level and aggregate investment is still far from being conclusive. Seemingly well established however is the view that the workhorse of the neoclassical investment model, the q-model of investment, has a hard time explaining empirically observed patterns of investment. The question of which assumption of the neoclassical model leads to its failure to what extent is yet to be answered.
Beginning with Fazzari et al. (1988) the empirical literature has emphasized the role of financial factors in firm-level investment. More recently attention has been drawn to the role of non-convexities in the investment technology. This paper aims at merging both of these strands and shows that financial factors and non-convexities are both simultaneously important since each significantly influences the effect of the other.
This interaction has not been analyzed much, but very recently a few contributions have drawn attention to the issue: Holt (2003) provides a theoretical real options model of irreversible investment that shows how financial frictions and irreversibility of investment interact as complements, Whited (2004) provides evidence that firms which are identified as financially constrained exhibit investment spikes much less frequently, and Caggese (2003) develops a formal test for financial constraints based on the irreversibility of fixed investment.
Our approach differs in both methodology and focus from these studies: With non convex adjustment costs, firms invest infrequently and lump their investment projects. This opens two ways for finance to affect investment: First, finance can alter the target level of capital to which a company adjusts and secondly, it can influence the frequency at which investment projects are carried out.
When we asses empirically which of the two channels is more important, finance shows at best a minor influence on the capital levels that companies hold. By contrast however, finance has a significant influence on investment. In consequence, finance has only an intertemporal substitution effect, that is more liquidity speeds up investment.
This result itself is already informative in finding out about the actual form of frictions involved. For example, one would expect the relative strength of both effects (level vs. frequency) to be just the reverse in a model in which the main influence of finance comes via the cost of capital and convex adjustment cost lead to partial adjustment of the current stock of capital to its target level every period. In such model a change in finance translates into a change in the target level of capital to which actual capital smoothly adjusts over time, which marks a clear difference to our model of interacting frictions.
While this interaction between finance and non-convex adjustment costs has not been much analyzed, non-convexities themselves such as irreversibility or fixed costs of investment and other economies of scale have been discussed widely and have been theoretically analyzed in a very general framework by Abel and Eberly (1994). Empirical evidence for non-convexities is mostly drawn from the Longitudinal Research Database (LRD).
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