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The net worth trap: investment and output dynamics in the presence of financing constraints

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posted on 11.08.2020 by Jukka Isohätälä, Alistair Milne, Donald Robertson
This paper investigates investment and output dynamics in a simple continuous time setting, showing that financing constraints substantially alter the relationship between net worth and the decisions of an optimizing firm. In the absence of financing constraints, net worth is irrelevant (the 1958 Modigliani–Miller irrelevance proposition applies). When incorporating financing constraints, a decline in net worth leads to the firm reducing investment and also output (when this reduces risk exposure). This negative relationship between net worth and investment has already been examined in the literature. The contribution here is providing new intuitive insights: (i) showing how large and long lasting the resulting non-linearity of firm behaviour can be, even with linear production and preferences; and (ii) highlighting the economic mechanisms involved—the emergence of shadow prices creating both corporate prudential saving and induced risk aversion. The emergence of such pronounced non-linearity, even with linear production and preference functions, suggests that financing constraints can have a major impact on investment and output; and this should be allowed for in empirical modelling of economic and financial crises (for example, the great depression of the 1930

History

School

  • Business and Economics

Department

  • Economics

Published in

Mathematics

Publisher

MDPI

Version

VoR (Version of Record)

Rights holder

© The authors

Publisher statement

This is an Open Access Article. It is published by MDPI under the Creative Commons Attribution 4.0 Unported Licence (CC BY). Full details of this licence are available at: http://creativecommons.org/licenses/by/4.0/

Acceptance date

07/08/2020

Publication date

2020-08-10

ISSN

2227-7390

Language

en

Depositor

Prof Alistair Milne Deposit date: 7 August 2020

Licence

Exports