Working Paper Series, Sveriges Riksbank (Central Bank of Sweden)
The Effect of Cash Flow on Investment: An Empirical Test of the Balance Sheet Channel
Abstract: This paper tests the balance sheet theory, where the
status of balance sheets affects the economy´s response to monetary and
other shocks. The theory predicts a positive effect of cash flow on
investment, given fundamental determinants of investment. I use an
empirical method developed by Gilchrist and Himmelberg (1995, 1999), which
has previously only been used to study very large, publicly traded firms.
In contrast, this paper uses a large Swedish data set with many smaller
firms, where balance sheet effects are likely to be especially important. I
find that a firm´s cash flow has a positive impact on its investment,
controlling for any information in cash flow about investment
opportunities. As predicted by the balance sheet channel, the estimated
effect of cash flow on investment is especially large for firms which, a
priori, are more likely to be financially constrained (low-dividend, small
and non-group firms). Moreover, the investment-cash flow sensitivity is
significantly larger and more persistent during the first half of the
sample period, which includes a severe banking crisis and recession, than
during the second half.
Keywords: Financial frictions; balance sheet channel; financial accelerator; investment; cash flow; (follow links to similar papers)
JEL-Codes: C33; E22; E44; E50; (follow links to similar papers)
41 pages, April 1, 2009
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