Volatility and Growth: Credit Constraints and Productivity-Enhancing Investment

Abstract

We examine how credit constraints affect the cyclical behavior of productivity-enhancing investment and thereby volatility and growth. We first develop a simple growth model where firms engage in two types of investment: a short-term one and a long-term productivity-enhancing one. Because it takes longer to complete, long-term investment has a relatively less procyclical return but also a higher liquidity risk. Under complete financial markets, long-term investment is countercyclical, thus mitigating volatility. But when firms face tight credit constraints, long-term investment turns procyclical, thus amplifying volatility. Tighter credit therefore leads to both higher aggregate volatility and lower mean growth for a given total investment rate. We next confront the model with a panel of countries over the period 1960-2000 and find that a lower degree of financial development predicts a higher sensitivity of both the composition of investment and mean growth to exogenous shocks, as well as a stronger negative effect of volatility on growth.

The Impact of Uncertainty Shocks

“…Looking at individual events, it could be used, for example, to analyze the uncertainty impact of trade reforms, major deregulations, tax changes, or political elections. There are of course many other linked recent strands of literature, including work on growth and volatility such as Ramey and Ramey (1995) and Aghion, Angeletos, Banerjee, and Manova (2005), on investment and uncertainty such as Leahy and Whited (1996) and Bloom, Bond, and Van Reenen (2007), on the business-cycle and uncertainty such as Barlevy (2004) and Gilchrist and Williams (2005), on policy uncertainty such as Adda and Cooper (2000), and on income and consumption uncertainty such as Meghir and Pistaferri (2004). 6 Bernanke developed an example of uncertainty in an oil cartel for capital investment, while Hassler solved a model with time-varying uncertainty and fixed adjustment costs.…”

CREDIT CONSTRAINTS AND THE CYCLICALITY OF R&D INVESTMENT: EVIDENCE FROM FRANCE

“…However, this is only true to the extent that firms are not credit constrained. As emphasized by Aghion et al (2010), henceforth AABM, things become quite different when credit market imperfections prevent firms from innovating and reorganizing in recessions. In particular, suppose that firms can choose between short‐run capital investment and long‐term R&D investment, that innovating requires that firms survive short‐run liquidity shocks, and that to cover liquidity costs firms can rely only on their short‐run earnings plus borrowing.…”

R&D, Credit Constraints, and Demand Fluctuations

“…Her theory also claims that the Schumpeterian virtue of bad times holds only if the marginal opportunity cost of productivity-enhancing investments dominates the marginal expected return. Aghion et al (2005) and Aghion et al (2010) also provide empirical support for their model. Their analysis from a panel of twenty-one Organization for Economic Cooperation and Development (OECD) countries shows that long-term growthenhancing investments respond less to positive exogenous shocks in countries with more developed financial sectors.…”

“…The seminal model of Aghion et al (2005) and Aghion et al (2010) argues that in the absence of credit constraints, investments that enhance long-term growth behave in a countercyclical manner, contrary to short-term investments. Aghion Downloaded by [New York University] et al (2010), however, claim that given credit constraints, long-term investments become procyclical.…”

“…Aghion Downloaded by [New York University] et al (2010), however, claim that given credit constraints, long-term investments become procyclical. The model of Aghion et al (2005Aghion et al ( , 2010 identifies a propagating mechanism that credit constraints have on the cyclical composition of investment. In particular, there is a wedge that reflects the probability of failure determined by the allocation of investments between the short and long runs.…”