The Effect of Cash Flow on Investment: An Empirical Test of the Balance Sheet Channel

Sveriges Riksbank Research Paper Series No. 59

Sveriges Riksbank Working Paper Series No. 228

38 Pages Posted: 12 Oct 2009

See all articles by Ola Melander

Ola Melander

Stockholm School of Economics

Date Written: April 1, 2009

Abstract

This paper tests the balance sheet theory, where the status of balance sheets affects the economy's response to monetary and other shocks. The theory predicts a positive effect of cash flow on investment, given fundamental determinants of investment. I use an empirical method developed by Gilchrist and Himmelberg (1995, 1999), which has previously only been used to study very large, publicly traded firms. In contrast, this paper uses a large Swedish data set with many smaller firms, where balance sheet effects are likely to be especially important. I find that a firm's cash flow has a positive impact on its investment, controlling for any information in cash flow about investment opportunities. As predicted by the balance sheet channel, the estimated effect of cash flow on investment is especially large for firms which, a priori, are more likely to be financially constrained (low-dividend, small and non-group firms). Moreover, the investment-cash flow sensitivity is significantly larger and more persistent during the first half of the sample period, which includes a severe banking crisis and recession, than during the second half.

Keywords: financial frictions, balance sheet channel, financial accelerator, investment, cash flow

JEL Classification: C33, E22, E44, E55

Suggested Citation

Melander, Ola, The Effect of Cash Flow on Investment: An Empirical Test of the Balance Sheet Channel (April 1, 2009). Sveriges Riksbank Research Paper Series No. 59, Sveriges Riksbank Working Paper Series No. 228, Available at SSRN: https://ssrn.com/abstract=1483016 or http://dx.doi.org/10.2139/ssrn.1483016

Ola Melander (Contact Author)

Stockholm School of Economics ( email )

PO Box 6501
Stockholm, 11383
Sweden

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