Financial constraints, inventory investment and fixed capital

Abstract

In a series of empirical studies Fazzari and Petersen (FP) and their associates examined the substitutability between the stock of fixed capital and inventory investment of firms when they encounter short run and/or sporadic financial constraints. They consider the cashflow constraint as the major source of adjustments. In addition, they argue that the cost differential between external and internal finances makes adjustments in capital investments difficult. Hence, inventory investment is expected to bear the brunt of the adjustment. However, a myopic firm may prefer to increase sales and augment short term cashflows when confronted with a financial constraint. Inventory investment may therefore decrease along with a reduction in fixed capital investments. The firm has many more options if the financial constraints persist. A more satisfactory theoretical explanation for the relationship between the financial constraints and investments in inventories and fixed capital is therefore necessary. This study sets up a comprehensive theoretical framework and demonstrates that changes in cost of production and other logistic costs will be the primary channel through which financial constraints affect investment in inventories and fixed capital. Many other important insights into the transmission mechanism have been highlighted