Firm Behaviour Under the Threat of Liquidation: Implications for Output, Investment & Business Cycle Transmission

Cash balances of the firm follow a diffusion process, triggering liquidation when they cross a threshold value. Access to external funds is constrained. Shareholders are impatient. With these assumptions there is a precautionary motive for retaining earnings; the internal cost of funds and local risk-aversion are decreasing functions of net worth; and, in extensions of our basic model, output and investment are increasing functions of net worth. We numerically simulate aggregate behaviour of a population of such firms. Shocks to net worth lead to substantial and prolonged deviations from steady state, consistent with a financial mechanism of business cycle transmission.