ABSTRACT
Analysts from all parts of the political spectrum see capital investment as central to current policy debates. Because of the many links between investment and financial markets, a complete discussion of monetary and financial policy options must address the impact of policy on investment.
Monetary policy is widely believed to have an important influence on the course of macroeconomic fluctuations. The research presented here makes clear that investment cannot be divorced from the state of the economy. Lower sales reduce the need to expand capacity. A weak economy lowers profits, reducing firms’ internal means of financing investment. Tighter lending requirements that emerge as profits and sales fall (the recent “credit crunch,” for example) also limit investment. These channels must be taken into account in assessing the impact of monetary decisions.
Although these macroeconomic effects are very strong empirically, interest rates constitute the primary link between money and investment in most accounts. That is, changes in the money supply affect investment because they change interest rates. Yet, measuring the sensitivity of investment to interest rates has been the subject of years of controversy in the empirical literature. It is by no means obvious that interest rates play a particularly significant role in explaining fluctuations of investment. Indeed, the empirical study presented here fails to find a reliable impact of interest rates on investment spending.
Recent research, however, has resurrected earlier ideas that the availability of finance, either through firms’ internal cash flow or from external debt, plays a fundamental role in determining the course of private investment. These “finance effects” on investment are separate from the traditional interest-rate/cost-of-capital channel, and they are possibly more potent. The effects of monetary policy on the cost of credit may not be particularly important for investment, but the effect of monetary policy and, more broadly, the institutional structure of the financial system may be 36significant for the availability of credit. Therefore, if one focuses on interest rates alone, one could underestimate the importance of monetary policy for investment.
More concretely, one consequence of using tight monetary policy to fight inflation may be weak investment, not necessarily because tight money raises interest rates but because of its macroeconomic impact on firms’ profits, cash flow, and credit availability. In addition, the research presented here applies to policies that affect the financial structure of firms. For example, the leveraged-buyout wave raised debt and substantially weakened balance sheets. The affected firms will be less able to maintain investment and innovative activity in a downturn, hurting productivity and inhibiting economic recovery. Therefore, we must look hard at policies that encourage debt (the tax deductibility of interest, for example). A high debt environment is less likely to provide the stable financial base necessary for capital expansion.
Finally, the new view of the investment-finance interaction implies that all firms and all investment projects are not equally affected by financial conditions. Mature firms may be able to replace internal funds or bank credit with some other form of funding during a monetary tightening. These substitution possibilities may not be available to firms in new, growth industries. Evidence presented here supports the conclusion that tight credit conditions are likely to disproportionately affect smaller, fast-growing firms in new, relatively high technology industries. The result is that monetary policy could have an inadvertent impact on the allocation of investment, not simply on its level.
