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The Effect of Cash Flow on Investment: An Empirical Test of the Balance Sheet Channel

Author

Listed:
  • Melander, Ola

    (Research Department, Central Bank of Sweden)

Abstract

This paper tests the balance sheet theory, where the status of balance sheets affects the economy´s response to monetary and other shocks. The theory predicts a positive effect of cash flow on investment, given fundamental determinants of investment. I use an empirical method developed by Gilchrist and Himmelberg (1995, 1999), which has previously only been used to study very large, publicly traded firms. In contrast, this paper uses a large Swedish data set with many smaller firms, where balance sheet effects are likely to be especially important. I find that a firm´s cash flow has a positive impact on its investment, controlling for any information in cash flow about investment opportunities. As predicted by the balance sheet channel, the estimated effect of cash flow on investment is especially large for firms which, a priori, are more likely to be financially constrained (low-dividend, small and non-group firms). Moreover, the investment-cash flow sensitivity is significantly larger and more persistent during the first half of the sample period, which includes a severe banking crisis and recession, than during the second half.

Suggested Citation

  • Melander, Ola, 2009. "The Effect of Cash Flow on Investment: An Empirical Test of the Balance Sheet Channel," Working Paper Series 228, Sveriges Riksbank (Central Bank of Sweden).
    • Handle: RePEc:hhs:rbnkwp:0228
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    File URL: http://www.riksbank.se/upload/Dokument_riksbank/Kat_publicerat/WorkingPapers/2009/wp228.pdf
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    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
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    Cited by:

    1. Alex Clymo, 2019. "Dispersion Over the Business Cycle: Productivity versus Demand," 2019 Meeting Papers 1125, Society for Economic Dynamics.
    2. Carlsson, Mikael & Messina, Julián & Nordström Skans, Oskar, 2014. "Firm-level shocks and labor adjustments," Working Paper Series 2014:28, IFAU - Institute for Evaluation of Labour Market and Education Policy.
    3. Mikael Carlsson & Julián Messina & Oskar Nordström Skans, 2016. "Wage Adjustment and Productivity Shocks," Economic Journal, Royal Economic Society, vol. 126(595), pages 1739-1773, September.
    4. Nehrebecki Marian, 2020. "Cash flow sensitivity of investment: Evidence from the Polish listed companies," Central European Economic Journal, Sciendo, vol. 7(54), pages 157-171, January.
    5. aus dem Moore, Nils, 2014. "Corporate Taxation and Investment: Evidence from the Belgian ACE Reform," Ruhr Economic Papers 534, RWI - Leibniz-Institut für Wirtschaftsforschung, Ruhr-University Bochum, TU Dortmund University, University of Duisburg-Essen.
    6. Carlsson, Mikael & Clymo, Alex & Joslin, Knut-Eric, 2022. "Dispersion Over The Business Cycle:Passthrough,Productivity, And Demand," Working Paper Series 414, Sveriges Riksbank (Central Bank of Sweden).
    7. repec:zbw:rwirep:0534 is not listed on IDEAS
    8. repec:spo:wpmain:info:hdl:2441/4v8c8tnfgu8g392dpm6uaefuus is not listed on IDEAS
    9. Nils aus dem Moore, 2014. "Corporate Taxation and Investment: Evidence from the Belgian ACE Reform," Ruhr Economic Papers 0534, Rheinisch-Westfälisches Institut für Wirtschaftsforschung, Ruhr-Universität Bochum, Universität Dortmund, Universität Duisburg-Essen.
    10. repec:hal:spmain:info:hdl:2441/4v8c8tnfgu8g392dpm6uaefuus is not listed on IDEAS

    More about this item

    Keywords

    Financial frictions; balance sheet channel; financial accelerator; investment; cash flow;
    All these keywords.

    JEL classification:

    • C33 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Models with Panel Data; Spatio-temporal Models
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General

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