Firms’ precautionary savings and employment during a credit crisis

Can the macroeconomic effects of credit supply shocks be large even in an economy in which the share of credit-constrained firms is small? I address this question using a model with firm heterogeneity, in which the interaction between real and financial frictions gives rise to precautionary cash holdings. Using UK firm-level balance sheet data, I show that firms hoarded cash relative to their assets during the last recession, and cash-intensive firms cut their workforces by less. A quantitative version of the model, disciplined by these data, generates similar dynamics in response to a tightening of firms’ credit conditions. The simulated economy experiences a sizeable fall in aggregate employment and prolonged substitution from capital to cash. Most of the aggregate dynamics are driven by unconstrained firms, pre-emptively responding to changes in credit conditions, in anticipation of future idiosyncratic productivity shocks. The model’s ability to generate predictions in line with the data crucially relies on this precautionary channel.