Financial Heterogeneity, Investment, and Firm Interactions

IMF Working Papers, May 26, 2023

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Corporate indebtedness affects firm-level investment behavior but not necessarily aggregate business cycles according to recent literature.
Interactions among heterogeneous firms play an important role in equilibrium.
After a downturn, financially unconstrained firms in financially constrained industries significantly increase capital expenditure to substitute depressed investment by their financially constrained competitors.
The increase in investment is primarily driven by small and medium firms and leads to substantial gains in future sales.
Equilibrium effects are unambiguously countercyclical because the increase in investment by unconstrained firms does not crowd out investment by financially constrained competitors.
The paper underscores a “competitive interaction channel” that may mitigate the impact of negative shocks in macroeconomic models with financial heterogeneity.

Financially unconstrained firms substitute for depressed investment by financially constrained competitors within the same industry.
The substitution effect is concentrated in small and medium firms, which account for the primary increase in capital expenditure after downturns.
The substitution generates substantial gains in future sales for the unconstrained firms undertaking additional investment.

The author uses a new empirical approach to identify equilibrium effects stemming from firm interactions under financial heterogeneity.
The empirical strategy yields a clear result: equilibrium effects are countercyclical because unconstrained firms’ increased investment does not crowd out investment by constrained firms.
The identified “competitive interaction channel” provides a mechanism through which negative shocks can be mitigated at the industry and aggregate levels.

Models of macroeconomic dynamics with financial heterogeneity should incorporate firm interactions and the competitive interaction channel to more accurately capture post-downturn adjustment.
Policy assessment of corporate indebtedness and financial constraints should consider cross-firm substitution effects and the role of small and medium firms in post-shock recoveries.