It has been seen that firms that resort to external financing have much higher Firm Investment Growth (Figi). There are many reasons behind this finding. One of them is that firms with better credit lines enjoy better returns on equity as compared to other firms. This means that firms with better credit lines are able to secure funding from investors which they can use to increase their value.
It is also seen that the effect of financial leverage on firm investment growth is very important for high information asymmetric companies. But no such relationship is found for low-information-based companies. Instead, firm growth is primarily dependent on market factors such as productivity growth, capital accumulation and market competition. With respect to market competition, government intervention may sometimes have a marginal impact on firms’ investments as well as productivity growth. But government intervention is considered to be a major factor for ensuring productivity growth especially in the manufacturing sector.
Further, there is a great variation across countries in the growth rates of firm investments. One country’s stimulus package may increase economic activity here but that same fiscal policy may lead to decreasing economic activity in another country with the exact opposite effect. It therefore becomes difficult to judge the role of government interventions and hence their effects on firm investments. Acknowledging this complication, it is understood that firm investments depend largely on macroeconomic indicators which are dynamic as well as cyclical.
It is further argued that increased government spending can raise the demand for assets in the short run, but this will not automatically lead to higher firm investments over the long term. According to this view, the long-run elasticity of capital formation is influenced by governmental policy interventions and therefore cannot be determined using a static approach. On the other hand, a number of researchers argue that there is a substantial negative correlation between fiscal policy and investment efficiency. This can be attributed to the fact that policy makers do not know what to invest in, and thus tend to choose low-return investments. As a result, these policies tend to lower investment efficiency.
In order to deal with this issue, many researchers suggest that policy makers must adopt a mixed investment approach. This means that, while they should continue to provide support for research and development, they also need to look to foster better domestic manufacturing. This can be done by improving the internal cash flow, promoting infrastructure development or offering incentives to firms that hire workers from their domestic population. By doing so, firms will be able to increase the rate of investment, boost the volume of exports and generate higher domestic output.
All said and done, it is important to highlight that firm research and development does not directly impact firm investment decisions. It is important for policy makers to understand that only investment decisions that do not affect future consumption can be considered as free-market choices. For instance, firms that choose to expand into unchartered industries are not necessarily being influenced by external factors; they are simply choosing to invest in a new line of business for which they can earn a higher return. As such, investment decisions made by firms need not be impacted by future market friction.