Investment dynamics with fixed capital adjustment cost and capital market imperfections

First version: April, 2001 This version: February, 2005 ABSTRACT This paper analyzes a model of investment with fixed investment costs and capital market imperfections. In this model finance influences the level of capital firms hold, as well as the frequency at which they invest. In consequence investment reacts nonlinearly with respect to shocks to productivity and liquidity. Liquidity and productivity shocks are complements and the influence of finance is strongest if a firm wishes to significantly adjust capital for fundamental reasons. This theoretical model is confronted with UK company data in a two-step estimation that first identifies the long-run relationship of productivity, capital and finance. Here we find no significant influence of finance on the capital decision of a firm. However, when the short-run investment function is estimated, finance has a significant impact, which is also strongest for strong fundamental investment incentives. Moreover, the investment function is strongly convex in the fundamentals themselves, indicating fixed costs of capital adjustment. JEL classification: E22; E44; G31; C32; C33