Liquidity Demand of Corporate Sector and Soft budget Constraint

This paper examines the relation between liquidity demands of corporate sector and investment decisions. It shows that the liquidity asset holding has two impacts on investments. First, the liquidity can absorb a liquidity shock and helps to continue a necessary project. Second, it helps to continue an undesirable project and decreases the incentive of firms. This negative aspect is quite similar to the soft budget constraint. According to these two impacts, firms must keep the optimal level of liquidity at the time of liquidity shock. If the value of liquidity asset fluctuates, however, it will become difficult to control the liquidity level. Hence the fluctuation of asset prices may decrease the aggregate investments even though all agents are risk neutral. Furthermore the paper also examines the impacts of investments on liquidity asset prices, and endogenously determines both asset prices and investment levels. It shows that even if the asset prices are expected to rise perfectly, aggregate investments should decrease as long as the growth rate of the prices is too high. It also examines the role of credit line offered by financial intermediaries. .