The effects of cash flows of nonfinancial firms on investment, on the bank loan market, and on monetary policy effectiveness

Date of Completion

January 1994


Economics, General




This dissertation examines the influence of internal cash flows of nonfinancial firms on the credit market and the monetary policy transmission mechanism. We find supportive evidence of the credit view of the monetary policy transmission mechanism, but the strength of the credit channel is reduced once cash flows are considered.^ We find that long-term movements in cash flow cause long-term movements in business investment. This relationship is traced to an accelerator-type investment mechanism. Using band spectral techniques, we document a close relationship between output and cash flow over low-frequency components, while output and interest rates do not affect investment.^ Chapter 3 examines the relationship between cash flow, the bank loan market, and the commercial paper market. The main hypothesis is that cash flow affects both loan demand and loan supply, and consequently commercial paper demand. Cash flow affects loan demand because cash flow replaces borrowed funds. The loan supply effects are traced to the signalling properties of cash flow and the credit worthiness of borrowers. The empirical work uses vector autoregressive models. In the 1970s, when the influence of the commercial paper market was low compared to later periods, there is a positive relationship between cash flow and bank loans. In the 1980s, there was tremendous growth in the importance of the commercial paper market, and we find an inverse relationship between cash flows and bank loans.^ We demonstrate that the money-interest rate relationship depends on the operating policy of the Federal Reserve. The money-interest rate relationship depends on two opposing effects: the liquidity effect, which suggests an inverse relationship, and an anticipated inflation effect, which suggests a positive relationship. The model shows that the liquidity effect dominates when the Federal Reserve targets money while the anticipated inflation effect dominates for an interest rate target. Using the Kalman filter, a time varying parameter model demonstrates that liquidity effect dominates since 1979 when it is generally understood that the Federal Reserve pursued a money target. ^