Policy Uncertainty and Cash Dynamics

Abstract

Why and when do firms optimally deviate from target cash? And why do we observe imperfect adjustment of cash? In this paper, we postulate and provide evidence that policy uncertainty induces financing frictions and adjustment costs which decelerate the speed of adjustment (SOA) of cash toward target. We also find that the effects of policy uncertainty on SOA are higher for firms that operate below target cash than for firms that operate above target cash. Firms that operate below target cash accelerate SOA while firms that operate above target cash decelerate SOA. Overall, the results suggest that in the face of policy uncertainty shocks, firms optimally deviate from target cash as the expected benefit of deviation is greater than the expected value of approaching the target.