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Inefficient Investment WavesZhiguo HeUniversity of Chicago - Booth School of Business, and NBER Peter KondorLondon School of Economics & Political Science (LSE); Central European University (CEU) August 1, 2014 Fama-Miller Working Paper Chicago Booth Research Paper No. 12-33 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.
Number of Pages in PDF File: 46 Keywords: Pecuniary externality, overinvestment and underinvestment, market intervention Date posted: March 15, 2012 ; Last revised: April 17, 2015Suggested CitationContact Information
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