Credit Constraints, Firms’ Precautionary Investment, and the Business Cycle

• BSE Working Paper: 110001 | September 15
• Keywords: Business cycles , financial frictions , Investment Choice , idiosyncratic production risk
• JEL codes: D92, E22, E32, G32
• Business cycles
• financial frictions
• Investment Choice
• idiosyncratic production risk

This paper studies the macroeconomic implications of firms’precautionary investment behavior in response to the anticipation of future financing constraints. Firms increase their demand for liquid and safe investments in order to alleviate future borrowing constraints and decrease the probability of having to forego future profitable investment opportunities. This results in an increase in the share of short-term projects that produces a temporary increase in output, at the expense of lower long-run investment and future output. I show in a calibrated model that this behavior is at the source of a novel and powerful channel of shock transmission of productivity shocks that produces short-run dampening and long-run propagation. Furthermore, it can account for the observed business cycle patterns of the aggregate and firm-level composition of investment.