Working Paper

Finance constraints, liquidity, and investment spending: theoretical restrictions and international evidence

Abstract: Theoretical and empirical models of investment spending have treated financial structure very differently. Recent research has begun to narrow this gap and, based on developments in the economics of information, has drawn theoretical links between investment spending and the frictions and constraints in financial markets. Furthermore, the sensitivity of investment to liquidity and other financial variables has been documented empirically for several industrialized countries. Despite this progress, the theoretical advances have not been exploited fully in econometric work, and questions remain concerning the interpretation of empirical results. To continue to narrow the gap between theoretical and empirical investment models, this paper studies finance constraints in a formal framework, explores their impact on the specification of Q investment equations, and develops two new tests of finance constraints that are evaluated for firms in several countries. While these tests provide some support for the importance of finance constraints, they temper previous conclusions and highlight the critical role for explicit theoretical models in guiding empirical research.

Bibliographic Information

Provider: Federal Reserve Bank of Kansas City

Part of Series: Research Working Paper

Publication Date: 1996

Number: 96-04