Financing Constraints, Irreversibility, and Investment Dynamics
We develop a structural model of an industry with many entrepreneurial firms in order to investigate the cyclical behaviour of aggregate fixed investment, variable capital investment and output. In particular, we consider an environment in which the entrepreneur cannot borrow unless the debt is secured by collateral and cannot sell fixed capital without liquidating her whole business. We show that, when these entrepreneurs experience persistent idiosyncratic and aggregate shocks, the inter-play between financing constraints and irreversibility of fixed capital is essential to explain several common observations. It helps to explain why inventory investment is very volatile and procyclical, especially during recessions, and why the output and inventories of small firms are more volatile and more cyclical than that of large firms. The model is also consistent with the observations that inventory investment leads the business cycle, and that both fixed and inventory investment are sensitive to the net worth of firms, even when marginal productivity of capital is taken into account.
We develop a model of an industry with many heterogeneous firms that face both financing constraints and irreversibility constraints. The financing constraint implies that firms cannot borrow unless the debt is secured by collateral; the irreversibility constraint that they can only sell their fixed capital by selling their business. We use this model to examine the cyclical behavior of aggregate fixed investment, variable capital investment, and output in the presence of persistent idiosyncratic and aggregate shocks. Our model yields three main results. First, the effect of the irreversibility constraint on fixed capital investment is reinforced by the financing constraint. Second, the effect of the financing constraint on variable capital investment is reinforced by the irreversibility constraint. Finally, the interaction between the two constraints is key for explaining why input inventories and material deliveries of US manufacturing firms are so volatile and procyclical, and also why they are highly asymmetrical over the business cycle.
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