Finance and the Optimal Investment Decisions of a Firm Under Imperfect Competition

Abstract

Both John Maynard Keynes and Hyman Minsky emphasized the effects of long-run expectations and financial structures on investment decisions. Minsky alleged that financial booms and collapses become inevitable in market economies and developed a new theory called the "financial instability hypothesis." In this paper, we construct an optimal-investment model under conditions of imperfect competition and explicitly represent the financing of investment. Our model demonstrates the micro-foundation of the investment theory of Keynes and Minsky. We show that both a firm's expected rate of growth and bank behavior play crucial roles in determining investment. For example, when the risk premium of a bank reacts elastically to the expected growth rate of demand, fluctuations in investment increase significantly and the range of fluctuation exceeds that in a perfect capital market. This means that the bank's behavior amplifies the fluctuations of the economy.