Scandinavian Working Papers in Economics
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Bank of Finland Research Discussion Papers, Bank of Finland

No 26/2014:
The net worth trap: investment and output dynamics in the presence of financing constraints

Jukka Isohätälä, Alistair Milne () and Donald Robertson

Abstract: We study the impact of financing constraints on investment and output dynamics, in a continuous time setting with output a linear function of capital. Decline of net worth reduces investment and, if firms can rent capital to unconstrained outside investors, can create a 'net worth trap' with both investment and output falling below normal levels for long time periods. We provide a detailed account of our model solution and discuss both the economic intuition underpinning our results and the implications for macroeconomic modeling.

Keywords: cash flow management; corporate prudential risk; the financial accelerator; financial distress; induced risk aversion; liquidity constraints; liquidity risk; (follow links to similar papers)

JEL-Codes: E44; (follow links to similar papers)

51 pages, November 6, 2014

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