Two opposing forces are at play with regard to the impact of economic growth on corporate liquidity. On one hand, a positive impact of economic growth on corporate liquidity is expected if firms hold more cash in anticipation of higher economic growth to take advantage of greater investment opportunities (Kim et al. 1998). On the other hand, higher economic growth implies higher opportunity cost of cash holdings because firms can invest idle cash in assets that yield higher real returns in anticipation of an economic boom. Hence, economic growth is expected to have a negative impact on corporate liquidity.
However, if the benefit of holding cash outweighs its cost when the economy is booming (i.e., the positive impact of economic growth on corporate liquidity is more overwhelming than its negative impact), corporate liquidity should have a positive relationship with economic growth. The hypo thesis is as follows:
Hypothesis 3: Economic growth should have a positive impact on corporate liquidity.
The impact of government deficit (focus of this study) on corporate liquidity is not as clear as the other macroeconomic conditions because government deficit signals changes in future macroeconomic conditions. Analysis of the signal effects of government deficits is helpful so that the net impact of government deficit on corporate liquidity can be better inferred. This study focuses on how government deficit affects corporate liquidity through inflation, interest rates, and economic growth. These variables are selected because they are more closely related to corporate liquidity (Garcia Teruel and Martinez Solano 2008; Kim et al. 2008). In addition, previous research has provided sufficient evidence on how government deficit is linked to these three macroeconomic variables (Saleh and Harvie 2005). further
Government deficits and inflation
Empirical evidence on the relationship between government deficit and inflation is mixed, depending on a variety of factors, such as country of study, degree of development, and methodologies used in the analysis. However, existing literature tends to support a positive relationship between government deficit and inflation (Choi and Devereux 2006; Fischer et al. 2002; Kia 2006; Sill 2005). For example, a cross-country study by Fischer et al. reveals a positive relationship between government deficit and inflation. This positive relationship is more pronounced in countries with hyperinflation and high inflation where government deficit is more likely to be financed by money creation (monetisation), which worsens government deficit further; that is, government deficit and inflation feed on each other in such countries.
Such a positive relationship is also observed by Sill. Developing countries are shown to generally see a strong and positive relationship between government deficit and inflation as opposed to developed countries. This is because developing countries usually finance government deficit via debt monetisation. Overall, existing empirical evidence indicates that government deficit is positively related to inflation in high-inflation countries or developing countries.