Abstract
Why do U.S. firms hold much more cash now than they did 30 years ago? I construct an industry equilibrium model of firm dynamics where cash provides a buffer against cash-flow shortfalls in the presence of costly external finance. My model finds that 63% of the increase in corporate cash holdings of small public firms can be accounted for by the increase in cash flow volatility. The increase in cash flow volatility observed in the data arises from a decrease in the correlation between revenue and operating expenses. The model has a corresponding correlation parameter between the shocks on revenue and operating expenses and only this parameter is changed in the primary experiment. In addition, the model allows for the possibility of negative cash flows. Negative cash flows are frequently observed in the data and are an important determinant for cash holdings.
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