The Cyclical Dynamics of Investment: The Role of Financing and Irreversibility Constraints

This paper develops a rich decision theoretic dynamic ¯rm model that analyzes productivity and interest rate shocks. The model is used to analyze the cyclical dynamics of fixed and inventory investment and in particular asks whether constraints to the flow of funds can generate the frequently overlooked fact that investment in input inventories leads investment in fixed capital in business cycle frequencies. To account for this regularity the model proposes a combination of irreversibility and financing constraints. The usefulness of this explanation in relation to competing hypotheses, relies on the fact that it is also consistent with a list of facts from the inventory research. In addition it is shown that under persistent shocks, financing constraints are sufficient but not necessary to explain procyclicality. This implies that fixed investment cash flow regressions may not be informative for the presence of capital market imperfections because positive correlations can arise even under perfect capital markets. Last, analysis of interest rate shocks implies that the effects on inventory spending are quite small in relation to effects arising from productivity shocks.