Firm Balance Sheet Liquidity, Monetary Policy Shocks, and Investment Dynamics

This paper asks whether corporate leverage or corporate liquid-asset (“cash”) holdings better predict which firms’ investment is most sensitive to monetary policy, challenging the conventional treatment of cash as simply “negative debt.” Using local projections (following Jordà 2005) on a Compustat panel and monetary policy shocks identified from high-frequency fed funds futures surprises, the paper finds that both higher leverage and lower liquid-asset ratios independently predict weaker capital accumulation for two to three years after a contractionary shock (a 10-percentage-point higher leverage ratio or 10-point lower liquid-asset ratio predict roughly 0.2 and 0.4 percentage points of additional cumulative capital-growth slowdown, respectively), but once both variables are included jointly, leverage loses its statistical significance while liquid assets remain robustly predictive – evidence, the paper argues, that the cross-sectional negative correlation between leverage and cash holdings creates an omitted-variable bias in leverage-only specifications common in the earlier literature. To explain why liquidity, not leverage, is the more robust predictor, the paper builds a heterogeneous-firm general equilibrium model in the Khan-Thomas (2013) tradition, modified with a fixed cost of issuing long-term debt, which breaks the standard equivalence between cash and negative debt: because debt issuance is lumpy, many firms optimally choose to hold sizeable cash buffers between infrequent debt issuances rather than paying down debt to zero, so their liquid-asset position, not their current leverage, governs how exposed they are to a monetary tightening’s effect on borrowing costs and cash flow. Calibrated to match firm-level investment, debt-issuance, and lifecycle facts, the model reproduces the paper’s central empirical pattern – liquid assets subsume leverage’s explanatory power once both are included – something a conventional liquid-debt version of the same model (without fixed issuance costs) cannot do, since there every firm with nonzero debt remains continuously exposed to the current borrowing rate, keeping leverage a strong independent predictor. The fixed issuance costs also generate a class of relatively large, high-net-worth firms that are not borrowing-constrained yet optimally choose not to raise new debt or accumulate cash in a given period – exact corporate analogues of the “wealthy hand-to-mouth” households of Kaplan and Violante (2014) – with a marginal propensity to invest out of a transitory cash windfall of essentially one; in the calibrated model these “liquidity-constrained” firms hold roughly a third of aggregate capital, versus under 8% held by firms at a binding borrowing constraint. Because of this large mass of high-marginal-propensity-to-invest firms, the model’s response to an unexpected, deficit-financed government transfer to the corporate sector is roughly three times larger on impact than in a recalibrated model without issuance costs, illustrating that balance-sheet liquidity, not leverage, is the more relevant margin for the transmission of shocks and policies that operate through firms’ cash flows.

Priit Jeenas | Macro Paper Warehouse

Firm Balance Sheet Liquidity, Monetary Policy Shocks, and Investment Dynamics