Can Capital Adjustment Costs Explain the Decline in Investment-Cash Flow Sensitivity?

It is well documented that since at least the 1970s investment-cash flow (I-CF) sensitivity has been decreasing over time to disappear almost completely by the late 2000s. Based on a neoclassical investment model with costly external financing, we show that this pattern can be explained by the gradual increase of capital adjustment costs. The result is corroborated in the supplementary analysis that exploits the cross-country and cross-industry variation of capital adjustment costs, as proxied by the level of technological advancement. More generally, our findings demonstrate that I-CF sensitivity should only be interpreted as a joint measure of financial and real frictions.