External Financing and Customer Capital: A Financial Theory of Markups

Abstract

We propose a dynamic structural corporate model in which firms face imperfect capital markets and frictional product markets. We highlight the importance of the endogeneity of firms' short-term cash flows and the endogeneity of the marginal value of liquidity in determining the interactions between investment, financing and product price setting decisions. Our primary goal is to develop a financial theory of markups to advance the understanding of two related questions in Macro Finance. One is how financial frictions affect firms' markups, and the other is how nominal frictions impact managers' financial decisions and firms' values. The model implies several testable predictions: (1) financially constrained firms are more inclined to increase their desired markups of products; (2) firms facing larger price stickiness tend to issue less external equity and conduct less big payouts; (3) a large part of the cost from price stickiness is induced by financial frictions; and (4) the impact of price stickiness on firms' investment ratios is ambiguous, due to the countervailing forces of precautionary cash holdings and the change in the cost of capital.