Finance Constraints, Liquidity, and Investment Spending: Theoretical Evidence and International Evidence

Robert S. Chirinko
October 1996
RWP 96-04
Research Division
Federal Reserve Bank of Kansas City

ABSTRACT

Theoretical and empirical models of investment spending have treated financial structure very differently. Recent research has begun to narrow this gap and, based on developments in the economics of information, has drawn theoretical links betweeen investment spending and the frictions and constraints in financial markets. Furthermore, the sensitivity of investment to liquidity and other financial variables has been documented empirically for several industrialized countries. Despite this progress, the theoretical advances have not been exploited fully in econometric work, and questions remain concerning the interpretation of empirical results. To continue to narrow the gap between theoretical and empirical investment models, this paper studies finance constraints in a formal framework, explores their impact on the specification of Q investment equations, and develops two new tests of finance constraints that are evaluated for firms in several countries. While these tests provide some support for the importance of finance constraints, they temper previous conclusions and highlight the critical role for explicit theoretical models in guiding empirical research.

Keywords: Finance Constraints, Financial Structure, Liquidity, Investment spending

JEL Nos. E22, E44.

Robert S. Chirinko is an associate professor of economics at Emory University and a visiting scholar at the Federal Reserve Bank of Kansas City. He would like to thank an anonymous referee, Robert Carpenter, Charles Calomiris, Robert Eisner, Julie Ann Elston, Harry Garretsen, Leo de Haan, Fumio Hayashi, Patrick Honohan, Brad Humphreys, Daniel Levy, Jonathan Neuberger, William Osterberg, James Poterba, Huntley Schaller, and seminar participants at the Federal Reserve Bank of Kansas City for their assistance or comments on a previous draft. Financial support from the Prudential Foundation and the Canadian Embassy under its Faculty Research Grant Program is gratefully acknowledged. All errors, omissions, and conclusions remain the sole responsibility of the author. The views expressed herein do not necessarily reflect those of the Federal Reserve Bank of Kansas City, the Federal Reserve System, or the sponsoring institutions. E-mail: rchirin@emory.edu.

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