Does too much liquidity generate instability?

Abstract

Abstract Corporate demand for cash is related to a number of firm-specific characteristics, like the presence of transaction costs, information asymmetry in credit markets, uncertainty and risk aversion. The purpose of this paper is to build a dynamic model that describes the potential chaotic effects of the accumulation of cash by firms over a prolonged period of time. By exploring the theoretical connections between firm financial policies and investment decisions, we show that too much liquidity might generate economic instability. When firm increases the share of cash devoted to risky investment, and reduces the share of cash distributed to shareholders as dividends, the fixed point of the system changes from being stable to being unstable. Moreover, the impact of such a policy on the stability of the system is larger the greater the investment risk. The chaotic behavior is mainly observable in the dynamics of cash, which in turn may affect all investment decisions.

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