Credit constraints, firms׳ precautionary investment, and the business cycle

Credit constrained firms prefer types of capital that generate significant pledgeable output and are liquid, since they loosen current and future credit constraints. Because pledgeability and liquidity are low for long-term firm-specific capital, a negative temporary aggregate productivity shock that tightens credit constraints creates a bias towards liquid short-term investments. This dampens the short-run negative output reaction to the shock, at the expense of strong medium-run propagation effects. This mechanism can create a short-run expansion when a future tightening in credit conditions is anticipated. •Some types of capital have more difficulty attracting external finance than others.•Credit constrained firms suboptimally underinvest in those types of capital.•Capital that produces payoffs early and has a high resale value is preferred.•Negative shocks are dampened by inducing a shift to liquid short-term investments.•A short run expansion can occur when a worsening of credit conditions is anticipated.