Financial Constraints, Precautionary Saving and Firm Dynamics

Publication Date
Financial Markets Group Discussion Papers DP 338
Publication Authors

This paper proposes a structural model that analyses the way financing constraints affect investment, consumption and saving decisions of the entrepreneur of a small/medium firm. The entrepreneur may face financing constraints because he cannot precommit to repay debt, unless the debt is secured by collateral. In addition he cannot retain all earnings, because a fraction of returns is non tradable and can only be consumed. These assumptions generate a precautionary saving effect: the proportion of wealth allocated between risky projects and safe assets depends on future expected financing problems. The model explains why small firms are on average more financially constrained, despite all firms are ex ante identical regarding their ability to access external finance. Model’s simulations are shown to be consistent with the empirical evidence about financing constraints and firm dynamics: at the micro level, firm investment depends on cash flow variations not related to changes in expected profitability. At the aggregate level, small firms experience more procyclical variation in sales, investment and short term debt than larger firms do. Another interesting result is that credit availability is more effective than interest rate in propagating monetary policy for financially constrained (small) firms, while interest rate is more effective for unconstrained (large) firms.