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Despite mixed results on the relationship between government deficit/spending and other macroeconomic variables (i.e., inflation, interest rate, and economic growth), empirical evidence tends to support the hypothesis that government deficits signal an increase in inflation particularly in developing countries, which should reduce corporate demand for cash because real purchasing power becomes lower. In addition, empirical studies support the positive relationship between government deficit and interest rates. Hence, firms should hold less cash when government deficit is higher because the opportunity cost of holding cash becomes higher under such circumstances. Click Here
Furthermore, despite mixed results on how government deficits affect economic growth, existing literature tends to favor a negative effect of government deficit on economic growth. Market participants generally perceive government deficit to be bad for the future economy, implying a negative effect of government deficit on economic growth (Hartman 2007). Reduction in real purchasing power due to government deficit-induced inflation results in reduced demand for domestic production, such that economic growth is negatively affected. Hence, the inclination of firms to hold cash should weaken when government deficit is higher as future economic growth and investment opportunities are perceived to be lower. Government deficits create economic uncertainty; thus, corporations are likely to hold more cash as a precaution.
However, if the positive impact of government deficit on corporate cash holdings is overwhelmed by the negative impact of government deficit, cash holdings should decrease when government deficits are higher. The above reasoning is summarised below.
Hypothesis 4: Government deficit should have a negative impact on corporate liquidity.
As mentioned above, government deficits can signal changes in inflation, interest rates, and economic growth in the future. Hence, government deficits should exert an indirect impact on corporate liquidity. Specifically, when government deficits are higher, any negative impact of inflation and interest rates on corporate liquidity should be reinforced if higher government deficit signals an increase in inflation and interest rates, both of which should reduce corporate cash holdings.
In addition, any positive effect of GDP growth on corporate liquidity should be weakened by an increase in government deficits if government deficits signal an economic slowdown in the future, which should result in a decrease in corporate liquidity due to fewer investment opportunities. The following hypotheses are formulated:
Hypothesis 5: The negative impact of inflation on corporate liquidity should be reinforced when government deficits are higher.
Hypothesis 6: The negative impact of interest rate on corporate liquidity should be reinforced when government deficits are higher.
Hypothesis 7: The positive impact of economic growth on corporate liquidity should be weakened when government deficits are higher.