The dynamic relation between financial positions and investment: evidence from company account data

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Abstract
A key feature of recent financial business cycle theories is the existence of a two-way dynamic relation between financial factors and investment: over time firms' financial positions are affected by, and in turn affect, investment decisions. This paper investigates the dynamic interaction between financial conditions and investment by estimating and testing vector autoregressions on company account panel data for US manufacturing firms, while considering explicitly sectional and time heterogeneity. The results show that indicators of liquidity and solvency contain significant predictive information for investment at the firm level. We also find evidence of both cross-sectional and time heterogeneity: the role played by financial factors is significantly more important for highly leveraged than for low-debt firms; capital market frictions are shown to have asymmetric effects over the business cycle, displaying a larger impact in contractions than in expansions. Overall, the evidence supports the hypothesis that capital market imperfections have an important role in explaining aggregate cyclical dynamics.

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