Inefficient Investment Waves
46 Pages Posted: 15 Mar 2012 Last revised: 17 Apr 2015
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Inefficient Investment Waves
Inefficient Investment Waves
Date Written: August 1, 2014
Abstract
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 simoultaneous waves in aggregate cash holdings, in market value of liquidity and in investment even if technology remains constant, consistently with firm-level and aggregate evidence. These investment waves are not constrained efficient in general, because the social and private value of liquidity differs. The resulting pecuniary externality affect incentives differentially depending on the state of the economy. There is often overinvestment in booms and underinvestment in recessions. In general, policies targeted to raise prices in recessions to mitigate underinvestment, make overinvestment in booms worse. However, a well designed price-support policy will increase welfare both in booms and in recessions.
Keywords: Pecuniary externality, overinvestment and underinvestment, market intervention
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