Inefficient Investment Waves

46 Pages Posted: 15 Mar 2012 Last revised: 17 Apr 2015

See all articles by Zhiguo He

Zhiguo He

Stanford University - Knight Management Center

Peter Kondor

London School of Economics & Political Science (LSE); Central European University (CEU)

Multiple version iconThere are 2 versions of this paper

Date Written: August 1, 2014

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 simoultaneous waves in aggregate cash holdings, in market value of liquidity and in investment even if technology remains constant, consistently with firm-level and aggregate evidence. These investment waves are not constrained efficient in general, because the social and private value of liquidity differs. The resulting pecuniary externality affect incentives differentially depending on the state of the economy. There is often overinvestment in booms and underinvestment in recessions. In general, policies targeted to raise prices in recessions to mitigate underinvestment, make overinvestment in booms worse. However, a well designed price-support policy will increase welfare both in booms and in recessions.

Keywords: Pecuniary externality, overinvestment and underinvestment, market intervention

Suggested Citation

He, Zhiguo and Kondor, Peter and Kondor, Peter, Inefficient Investment Waves (August 1, 2014). Fama-Miller Working Paper, Chicago Booth Research Paper No. 12-33, Available at SSRN: https://ssrn.com/abstract=2022525 or http://dx.doi.org/10.2139/ssrn.2022525

Zhiguo He (Contact Author)

Stanford University - Knight Management Center ( email )

655 Knight Way
Stanford, CA 94305-7298
United States

Peter Kondor

Central European University (CEU) ( email )

Nador utca 9
Budapest, H-1051
Hungary

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

HOME PAGE: http://fmg.lse.ac.uk/~kondor

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