Why Does Liquidity Matter in Investment Equations?

TLDR

Liquidity variables are widely accepted to affect investment spending, yet questions remain about their interpretation, sources, and the economic importance of finance constraints. The study addresses these questions by estimating econometric models that exploit Canadian institutional features to identify firms with severe information problems. The authors estimate econometric models that use Canadian institutional features to identify firms facing severe information problems. The evidence confirms finance constraints exist and are driven by firms’ difficulties in credibly communicating private information, a conclusion robust to biases from asset pricing, scale economies, or imperfect competition. © 1995 Ohio State University Press.

Abstract

That liquidity variables affect investment spending is widely accepted. Despite important recent empirical work, questions remain concerning the interpretation of liquidity variables in investment equations and the sources and economic importance of finance constraints. These questions are addressed by estimating a variety of econometric models that exploit distinctive Canadian institutional features to identify firms that face relatively severe information problems. The initial econometric evidence confirms the existence of finance constraints, and identifies their source as the problems faced by firms in credibly communicating private information to outsiders. This conclusion is robust to biases from the capitalization of finance constraints into asset prices, scale economies, or imperfect competition, which are accounted for directly in the econometric specifications. Copyright 1995 by Ohio State University Press.