Does too much liquidity generate instability?
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Does too much liquidity generate instability? Giorgio Calcagnini1 · Laura Gardini1 · Germana Giombini1 Edgar S. Carrera1
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Received: 5 March 2020 / Accepted: 8 August 2020 © The Author(s) 2020
Abstract Corporate demand for cash is related to a number of firm-specific characteristics, like the presence of transaction costs, information asymmetry in credit markets, uncertainty and risk aversion. The purpose of this paper is to build a dynamic model that describes the potential chaotic effects of the accumulation of cash by firms over a prolonged period of time. By exploring the theoretical connections between firm financial policies and investment decisions, we show that too much liquidity might generate economic instability. When firm increases the share of cash devoted to risky investment, and reduces the share of cash distributed to shareholders as dividends, the fixed point of the system changes from being stable to being unstable. Moreover, the impact of such a policy on the stability of the system is larger the greater the investment risk. The chaotic behavior is mainly observable in the dynamics of cash, which in turn may affect all investment decisions. Keywords Corporate finance · Firm liquidity · Volatility · Instability · Chaos
This paper benefited from comments and suggestions from participants at the: seminar held at the New College of Humanities, London, June 25 2019; ‘11-th NED Conference’ held at the Kiev School of Economics on 4–6 September, 2019; and at the International Workshop “New Developments in Economic Dynamics” organized by DESP held in Urbino, November 5, 2019. Financial support from the research project on “Models of behavioral economics for sustainable development” financed by DESP-University of Urbino is gratefully acknowledged. The usual disclaimer applies.
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Germana Giombini [email protected] Giorgio Calcagnini [email protected] Laura Gardini [email protected] Edgar S. Carrera [email protected]
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University of Urbino Carlo Bo, Urbino, Italy
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1 Introduction The purpose of this paper is to build a dynamic model that describes the potential chaotic effects of the accumulation of cash by firms over a prolonged period of time. While firms loaded with relatively more liquid assets may attract, from time to time, more investors’ and lenders’ attention than firms with low levels of cash, the former— by holding cash—may miss investment opportunities and—prospectively—be less profitable than the latter. Indeed, investors may take the excessive amount of cash as a sign that opportunities for significant growth no longer exist or that, in an imperfect information environment, agency problems do exist, and the stock price may be poised to decline (Gilchrist and Himmelberg 1995; Gilchrist et al. 2009, 2013, Adler et al. 2019). Therefore, traditional analyses of firms’ yearly balance sheet are only partially informative of their ability to generate wealth/income for their shareholders, while a dynamic model provides a better s
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