Cointegration and Error Correction Models: The Temporal Causality between Investment and Corporate Cash Flow

Abstract

It has been long recognized that business investment spending is one of the most volatile components of aggregate expenditures. For this reason, fluctuations in output and employment are more likely to reflect volatility of investment spending than changes in relatively stable components such as consumption expenditures. Among factors that may help to explain the unstable behavior of investment spending, the financing side of investment decisions has received renewed attention from both academics and the press. In the past decade or so, a number of theoretical arguments have been advanced suggesting that the ability of some firms in raising funds externally for investment purposes may be limited due to capital market imperfections such as transaction costs of issuing new bonds or shares and asymmetric information. The firms facing these financing constraints, therefore, may have to rely more heavily on their internal funds to finance investment projects than would have otherwise been the case. Consequently, the firms' investment expenditures become sensitive to variations in their sources of internal funds as measured by cash flow or closely related variables such as earnings or profits. A significant drop in cash flow of these firms, for example, may force them to pass up profitable investment opportunities. This may in turn cause an economic downturn or intensify a recession that is already underway. The emphasis on the influence of financing factors on investment decisions, however, may be traced back to the writings of Keynes (1936) and Kalecki (1971 [1937]). Moreover, Post Keynesian economists such