It is a commonly held view that the strength of firms’ balance sheets is relevant for investment dynamics in the macroeconomy, with their overall indebtedness (i.e., leverage) often considered to be a key factor influencing economic fluctuations. In the BSE Working Paper 1409, “Firm Balance Sheet Liquidity, Monetary Policy Shocks and Investment Dynamics,” Priit Jeenas studies how the liquidity of firms’ balance sheets (i.e., held cash), beyond their indebtedness, can affect the transmission of monetary policy to aggregate investment.
Firms with low liquid asset holdings exhibit relatively weaker fixed capital growth after unexpected policy rate increases.
Figure 1 displays the heterogeneity in firms’ responses of capital accumulation conditional on their liquidity (i.e., liquid to total assets) ratio. Negative estimates imply that firms with lower liquid asset holdings at the time of a contractionary monetary shock reduce their capital stock relative to others thereafter. The largest differences approximately 2 years after the shock imply that a 10 percentage point (pp) lower liquidity ratio predicts about 0.3 pp lower cumulative capital growth after a one standard deviation monetary policy contraction. This responsiveness is not explained by other firm characteristics which have received attention in the recent literature on heterogeneous monetary shock effects such as size, leverage, distance to default, age, debt maturity, or sector-specific demand elasticity.
Figure 1: Heterogeneity in responses of capital accumulation conditional on liquidity ratio
Further empirical evidence in the paper and in recently published independent work suggests that a mechanism which plays a key role in explaining these findings is firms’ ability to finance investment using liquid funds on hand, and that new debt is not necessarily the source of financing for all firms at all times. Firms with high liquidity at a given point in time are less reliant on the issuance of new debt and do not take interest rates on corporate debt as a relevant immediate opportunity cost of investment. Their decisions are thus relatively more disconnected from fluctuations in the cost of borrowing caused by monetary policy actions.
Direct monetary transmission to aggregate investment is dampened in the presence of firm liquidity management.
To introduce these ideas into a macroeconomic framework, the author develops a general equilibrium model of heterogeneous firms that introduces long-term debt financing and fixed debt issuance costs in a conventional framework with collateral constraints. The debt issuance costs give rise to a dampened exposure of firms’ investment to market interest rate fluctuations and monetary policy actions. This is illustrated by comparing the strength of the direct channels of monetary transmission in the baseline calibrated model to those in a “No liquidity” special case which does not model firms’ liquidity management considerations. (The direct channels of monetary transmission are understood as the effects of changes in interest rates, while fixing other prices faced by firms, such as wages or capital goods’ prices.) Table 1 shows that in the baseline model, the direct effect of a monetary policy shock on aggregate investment at impact () would be 4.14 times larger than the full general equilibrium effect. (The latter includes significant dampening because of capital prices changing.) In contrast, in the “No liquidity” model, the direct channel is 5.09 times larger than the general equilibrium effect.
Table 1: Relevance of direct channel in monetary transmission, in ratios to full response
Using the calibrated model, the author changes firms’ initial financial positions by providing them a transfer of liquid assets while increasing their debt positions to keep their net financial position fixed. Figure 2 (Panel a) presents the effects of a 25 bp monetary policy shock on aggregate capital one year after, comparing both the partial equilibrium (PE) and general equilibrium (GE) effects, with the former not incorporating the effects of the change in financial positions on prices. Compared to the drop of about 0.0195 per cent when considering the (unchanged) steady state distribution, a liquidity transfer of 6% of the firm’s capital stock implies a fall of about 0.0173 per cent in PE – a 1/8 weaker capital responsiveness coming from higher balance sheet liquidity, fixing net worth. Firms with more liquid balance sheets are less likely to issue new debt and are thus protected from temporary changes in rates on new loans and the stronger balance sheet channel. However, allowing for all prices to adjust and clear markets illustrates that in GE, the way how capital prices respond undoes much of the effect of the liquidity transfer and as a result, the fall in capital is about 0.0189 per cent – much closer to the steady state response.
Figure 2: Monetary transmission conditional on initial balance sheet liquidity distribution and on the sensitivity of liquid asset returns
Notes: Panel (a): Impulse response of aggregate capital one year after a 25 bp monetary shock, depending on the change to firms’ cash and debt positions (horizontal axis), with the green dotted and blue solid lines depicting the PE and GE responses. Panel (b): Range of impulse response paths of the economy’s capital stock to a 25 bp monetary shock, conditional on different values of liquid assets’ return sensitivity; solid blue line corresponding to baseline responsiveness, and dashed bounds depicting the PE (green dotted) and (blue dashed) effects of changing sensitivity from 0% to 100%; quarters since shock on horizontal axis.
Monetary transmission depends on the return characteristics of firms’ liquid asset portfolios.
The author also finds that if the nominal returns on firms’ liquid assets were insensitive to changes in the monetary policy interest rate (e.g., as the returns on non-interest-bearing currency are), then the effect of a monetary policy shock on the aggregate capital stock one year after would be about 4 times smaller than in the baseline calibration (Figure 2, panel b), fixing all price and interest rate paths other than the return on liquid assets (in PE). If a firm holds liquid assets, their return is a relevant opportunity cost for investing in capital. If, all else equal, returns on liquid assets increase by less, firms also reduce their capital investment by less. However, allowing for all prices to adjust when altering the sensitivity of the liquid asset return (in GE) shows again that the behavior of prices undoes most of the effects and the monetary transmission to the economy’s capital stock increases by only about 1/10 when going from fully insensitive liquid asset returns to the case where they perfectly comove with the monetary policy interest rate.
In sum, the author documents that firms with low liquid asset holdings exhibit relatively weaker fixed capital growth after unexpected policy rate increases. This responsiveness is not explained by other firm characteristics, such as leverage, default risk, size, or age. He develops a general equilibrium model of heterogeneous firms that introduces long-term debt financing and fixed debt issuance costs in a conventional framework with collateral constraints. The issuance costs give rise to firm liquidity management and debt issuance behaviour in line with the data and generate an endogenous disconnect of firms from the borrowing costs currently prevalent in the debt market. The model provides a novel framework that allows to evaluate the quantitative relevance of firms’ liquidity management for monetary transmission.
