plans in the face of changes in the volume and cost of external financing. However, the effects of financial imperfections can be asymmetric over the business cycle. In fact, when net worth is high (more likely to be the case during booms), the problems of adverse selection or moral hazard are less relevant (as lenders’ collateral requirements are less binding). Conversely, with adverse shocks, net worth-related constraints can suddenly become much more significant. The asymmetric nature of shocks has been exploited by the empirical literature to show the relevance of macro-financial linkages.

The key mechanisms described above are also relevant to understanding the implications of changes in household balance sheets. As is the case for corporations, the borrowing potential of households also hinges on the strength of their balance sheets. This means that movements in asset (such as house or equity) prices can lead to changes in household borrowing and spending that are larger than what is suggested by conventional life-time wealth and consumption effects (Claessens and Kose (2017)). Since housing represents a large part of household net worth, movements in house prices can affect homeowners’ access to financing and the external financing premium they face (Mian et al (2017)).

# B.  Empirical evidence

Numerous studies examine the empirical relevance of financial imperfections. Some employ microeconomic (firm-, household- and sector-level) data while others consider specific events or episodes. This section summarises the empirical evidence provided by microeconomic data (largely focusing on corporate investment and household consumption). Additional work that considers macroeconomic and time series evidence is presented in Section 7.

Research documents a strong association between firm cash flow and investment. Theory predicts that, in environments with no financial market imperfections, a corporation’s current cash flow is immaterial to its investment decision. With imperfections, however, a corporation’s cash flow can influence investment decisions because the corporation is subject to an external finance premium that stems from financing constraints. As the cash flow increases, so can investment because of the greater availability of internal funds and the lower cost of such funds relative to external funds. Many studies using panel data report that corporate cash flows are indeed correlated with investment decisions. This is especially true for firms that are smaller, do not pay dividends or have poor credit ratings, exactly those firms that are more likely to be subject to imperfections. The first influential paper that presents empirical evidence of this link, by Fazzari et al (1988), has been followed by many others.<sup>10</sup> The empirical evidence on the link between internal cash flows and investment shows that imperfections play a significant role. Although other factors can also lead to such linkages, studies using various techniques to control for such factors have confirmed the relevance of imperfections.<sup>11</sup> One confounding factor is that firms’ current cash flows can be correlated with future profitability. Since prospective returns are relevant to current investment decisions, this can generate a correlation (even without financial market frictions). Evidence shows, however, that imperfections remain important. For example, Blanchard et 10 Other studies include Hubbard (1998), Hoshi et al (1991), Whited (1992), Calomiris et al (1995), Gross (1995) and Hubbard et al (1995). Stein (2003) presents a survey of theoretical and empirical work regarding the determinants of firm-level investment dynamics.

11 For example, Kaplan and Zingales (1997) criticise the approach taken by Fazzari et al (1988) because they do not control for the endogeneity of financing constraints. See further Kaplan and Zingales (2000) on why investment-cash flow sensitivities are not good indicators of financing constraints.

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