The Effect of Stock Liquidity on the Firm's Investment and Production

Abstract

We propose that corporate investment is a declining function of stock illiquidity, which raises the firm’s cost of capital. This relation holds even for firms that are not financially constrained. Consequently, higher illiquidity induces firms to select a production process that is less capital intensive: they have higher output per unit of capital or higher marginal productivity of capital, lower capital/labor ratio, and lower operating leverage that means greater reliance on variable costs. The negative illiquidity-investment relation holds for an exogenous liquidity event – the 2001 decimalization – and remains after accounting for endogeneity by instrumental variable estimation.

Keywords: Liquidity, investment, production