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Inefficient investment waves

He Zhiguo and Péter Kondor ()

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: We show that firms' individually optimal liquidity management results in socially inefficient boom-and-bust patterns. Financially constrained firms decide on the level of their liquid resources facing cash-flow shocks and time-varying investment opportunities. Firms' liquidity management decisions generate simultaneous waves in aggregate cash holdings and investment, even if technology remains constant. These investment waves are not constrained efficient in general, because the social and private value of liquidity differs. The resulting pecuniary externality affects incentives differentially depending on the state of the economy, and often overinvestment occurs during booms and underinvestment occurs during recessions. In general, policies intended to mitigate underinvestment raise prices during recessions, making overinvestment during booms worse. However, a well-designed price-support policy will increase welfare in both booms and recessions.

Keywords: Pecuniary externality; overinvestment and underinvestment; market intervention (search for similar items in EconPapers)
JEL-codes: F3 G3 (search for similar items in EconPapers)
Date: 2016-03-01
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Published in Econometrica, 1, March, 2016, 84(2), pp. 735-780. ISSN: 0012-9682

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http://eprints.lse.ac.uk/64412/ Open access version. (application/pdf)

Related works:
Journal Article: Inefficient Investment Waves (2016) Downloads
Working Paper: Inefficient Investment Waves (2012) Downloads
Working Paper: Inefficient Investment Waves (2012) Downloads
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