Does too much liquidity generate instability?

Giorgio Calcagnini,Edgar S Carrera,Laura Gardini,Germana Giombini

doi:10.1007/s11403-020-00296-0

Giorgio Calcagnini, Edgar S Carrera + Show 2 more

Open Access

https://doi.org/10.1007/s11403-020-00296-0

Copy DOI

Abstract

Corporate demand for cash is related to a number of firm-specific characteristics, like the presence of transaction costs, information asymmetry in credit markets, uncertainty and risk aversion. The purpose of this paper is to build a dynamic model that describes the potential chaotic effects of the accumulation of cash by firms over a prolonged period of time. By exploring the theoretical connections between firm financial policies and investment decisions, we show that too much liquidity might generate economic instability. When firm increases the share of cash devoted to risky investment, and reduces the share of cash distributed to shareholders as dividends, the fixed point of the system changes from being stable to being unstable. Moreover, the impact of such a policy on the stability of the system is larger the greater the investment risk. The chaotic behavior is mainly observable in the dynamics of cash, which in turn may affect all investment decisions.

Highlights

The purpose of this paper is to build a dynamic model that describes the potential chaotic effects of the accumulation of cash by firms over a prolonged period of time
Traditional analyses of firms’ yearly balance sheet are only partially informative of their ability to generate wealth/income for their shareholders, while a dynamic model provides a better setup to study the complex structure of relationships and equilibria that characterize firms over time
We model a marginal efficiency of investment (MEI) curve that declines linearly, as the reliance on external finance for some portion of investment could lead to a downward sloping net MEI curve, if external financing is more costly and used for successively greater levels of investments (Shaffer 1991)

Summary

Introduction

The purpose of this paper is to build a dynamic model that describes the potential chaotic effects of the accumulation of cash by firms over a prolonged period of time. In the case of the U.S economy, many commentators have argued that companies have been hoarding cash while postponing investment projects because of a poor regulatory climate and excessive uncertainty Another frequently mentioned explanation for the high cash holdings of U.S firms is that repatriation of cash held abroad by multinational corporations has adverse tax consequences, and, it is advantageous for them to keep their profits abroad in the form of cash (Pinkowitz et al 2015). The authors show that endogenous risk due to adverse feedback loops is significantly larger away from the steady state, leading to nonlinearities: small shocks keep the economy near the stable steady state, but large shocks put the economy in the unstable crisis regime characterized by liquidity spirals In this vein, we develop a dynamical model for firms’ decisions related to their financial activities under excess liquidity.

The model

Equilibria and dynamics

The effects of changes in monetary policy

Conclusion

Findings

Compliance with ethical standards