Costly External Finance and Investment Efficiency in a Market Equilibrium Model

The corporate finance literature suggests that a financially constrained firm invests less than an identical unconstrained firm. This does not imply that financial frictions cause firms to invest less than in a frictionless economy. When firms compete for investment funds, an increase in financial frictions can lead individual firms to increase their investment levels. A greater than the frictionless level of investment is likely in low productivity firms, in cash-rich firms, and in firms with cheap external capital. Government programs that make capital cheaper for small firms may lead to lower levels of investment for all firms and decrease efficiency. Journal of Economic Literature Classification numbers: O16, E22, E44, G20 ∗Department of Economics, Queen’s University, Kingston, Canada. Fax: (613) 533-6668. E-mail: [email protected]. I would like to thank John Matsusaka, Oguzan Ozbas, and two referees for helpful comments and suggestions. I have also benefited from discussions with Huw Lloyd-Ellis, Fulvio Ortu, and David Scharfstein.