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Government Deficits and Corporate Liquidity: Hypotheses DevelopmentIn addition, an increase in government deficit also signals or results in changes in other macroeconomic conditions (Saleh and Harvie 2005). For example, increased government deficits are likely to raise interest rates because governments borrow to finance more expenditure by issuing debt at an attractive lower price (Premchand 1984). An increase in interest rates means higher opportunity cost of holding cash, which should result in a decrease in corporate money demand or cash holdings (Keynes 1936). Private investments are likely to be crowded out because of rising interest rates and reduced resources resulting from higher government spending and/or investment; therefore, economic growth is likely to slow down. Accordingly, firms should reduce cash holdings because the need for holding cash to anticipate and take advantage of greater investment opportunities decreases (Kim et al., 1998).
Given that changes in government deficits can signal changes in inflation, economic growth, and interest rates, it is important to analyze first how inflation, economic growth, and interest rate affect corporate liquidity before examining the net impact of government deficit on corporate liquidity.
Inflation
When inflation is higher, firms should reduce non-interest-bearing cash holdings because the real purchasing power of cash decreases, and cash is less valuable under such circumstances (Natke 2001). At the same time, firms can increase interest-bearing short-term investments or marketable securities, which are components of corporate liquidity in existing liquidity literature. Hence, the impact of inflation on corporate liquidity is ambiguous, depending on the relative magnitude of these two opposing effects. However, if interest-bearing short-term investments can be excluded (which is the case in this study), the positive impact of inflation on corporate liquidity should be minimal or none, such that corporate liquidity should be negatively related to inflation. The hypothesis is formulated below.
Hypothesis 1: Inflation should have a negative impact on corporate liquidity. further
Interest rate
Based on the prediction of money demand theory, when interest rates increase, firms should reduce non-interest-bearing cash holdings and increase investments in assets with higher real returns because the opportunity cost of holding cash becomes higher. As mentioned above, such negative effect is guaranteed because the cash variable in this study excludes short-term investments. However, another effect is also at play; that is, external financing is likely to become more costly when interest rates increase. It follows that firms should be inclined to hold more cash because internal financing is relatively cheaper under such circumstances. Hence, the net impact of interest rate on corporate liquidity is ambiguous, depending on the relative magnitude of these two opposing effects. However, if the positive effect of interest rates through external financing is overwhelmed by the negative effect of interest rate through the opportunity cost of holding cash, then a negative relationship between interest rates and corporate liquidity is expected. The above reasoning leads to the following hypothesis:
Hypothesis 2: Interest rate should have a negative impact on corporate liquidity.