Working Paper No. 111 Investment by Manufacturing Firms and the Transmission of Monetary Policy in Mexico

The behavior of investment by Mexican manufacturing firms is analyzed for the period 1984-1999, which can be characterized by several structural changes, i.e. financial liberalization, the re-privatization of commercial banks, significantly reduced the financing needs of the public sector, and an almost complete freezing of bank intermediation after the 1994 financial crisis. Standard investment equations are estimated with special attention paid to the relevant differences between the cost of internal versus external funds. This paper finds that internal funds, in the form of cash flow, have been significant in financing capital expenditures, especially by small firms. On the other hand, real interest rate movements also seem to have affected capital formation by firms throughout the period. Moreover, I find that capital expenditures by large firms are more responsive to real interest rate changes than investment by medium and small firms. This is evidence for the role of the credit channel of monetary policy. Finally, although I find that investment by small firms has become more responsive to changes in cash flow during the second half of the1990s, the interest rate elasticity of investment does not seem to have changed during the episodes that commonly characterized the evolution of credit markets in Mexico. * Paper presented at the Conference on Mexican Credit organized by the Center for Research on Economic Development and Policy Reform at Stanford University, October 5-6, 2001. I thank A. Tornell, J.A. González, C. Woodruff, M. Messmacher, L. Martínez, A. Werner, G. Marrufo, L. Videgaray for comments, and S. L. Orozco for research assistance. All remaining errors are mine, and the views expressed here do not necessarily coincide with those of the Bank of Mexico. Comments welcome at: [email protected].