Policy makers have traditionally considered the macroeconomic relations and the variables that can affect the economic objectives that they pursue, such as prices, employment, balance of payments, and economic growth. Recently, microeconomic behavior has also been considered. To complete the analysis, it is necessary to include those variables that define the firm's evolution and activities, and cash flow could be this kind of variable to be included in the analysis. The main objective of this paper is to show the relationship between cash flow and one of the final economic policy targets, economic growth. This paper considers the relationship between cash flow and applied economics, then develops the effects of cash flow on economic growth. (JEL: 040)
In applied economic analysis, decision makers have considered the variables that can affect the economic objectives that they pursue, such as prices, employment levels, balance of payments, and economic growth. These studies have been macroeconomic in nature, although in recent years, microeconomic behavior has also been considered. In spite of this new perspective, variables of managerial character are not usually included, so policy makers have no information about the effects that their measures have on the firm's evolution.
Therefore, the design and the derived effects of an anti-cyclical economic policy have been studied without considering their incidence on the evolution and plans of the firms. Generally, they have tried to affect investment decisions through an expansion of demand and interest rate variations.
To complete such analysis, it is necessary to include those variables that define the firm's evolution and activity. If this type of analysis is able to be developed, it is easy to know how to affect such variables and the effects of such variation on the firm's evolution. One will also be able to understand the effects of this variation on the final economic policy targets. Cash flow could be this kind of variable to be included in the analysis.
The main objective of this paper is to show the relationship between cash flow and one of the final economic policy targets, economic growth. The next section considers the relationship between cash flow and applied economics, followed by a development of the effects of cash flow on economic growth. The last section of the paper includes the main conclusions of the study.
Economic Policy and Cash Flow
It is well known that the activities carried out by firms are influenced from internal and external points of view. The internal view implies that, the decisions adopted in the core of the firm will affect the behavior of other functions, such as production, financing, and distribution. The external view considers the effects of firm productivity on various economic sectors and how economic policy could affect firm behavior. The latter will be considered in this paper.
When the policy maker designs measures, the main economic objectives and the variables that could help to obtain these results have to be considered. In this sense, factors such as interest rates, public consumption, and money supply are some variables that are usually considered from a macroeconomic point of view. From a microeconomic point of view, however, cash flow could also be taken into account.
According to Riebold [1969, p. 24], cash flow is the internal flow of the generation and use of money over a certain period of time. Accordingly, variations of cash flow affect the firm's production decisions [Rivera, 1989]. If there is an increase in cash flow, then production will most likely increase, indirectly improving economic activity (for example, through employment rates and economic growth).
In general terms, the policy maker could affect cash flow using fiscal or monetary policies. The effects of fiscal policy on cash flow are shown in Figure 1. An increase in public expenditure or a reduction of taxes will increase cash flow, however, the method of financing the public deficit will alter such a conclusion. In the case of public debt issues, the interest rate will increase. So, the cash flow of the firms with external indebtedness will be lower.
The effects of the monetary policy case are shown in Figure 2. It can be observed that money supply (M) variations also affect the variations in income. [Gonzalez, 1997; Hernando, 1997].
In this sense, it is also necessary to consider other economic activity behavior. First, credit institutions could maintain credit to their best clients, so the investment risk will be reduced. Second, the firm size, because bigger firms could present higher guarantees than the smaller firms, reducing the risk, so credit institutions will continue to grant the loan that the former ask.
Cash Flow Effects on Economic Growth
This section considers the cash flow effects on one final economic policy target, economic growth. To reach this objective, a group of relationships are developed considering the effect of the measures studied in the previous section. The analysis follows the approaches of Fry [1995, 1997], Ghatak , and Deninger and Squire .
The growth equation is expressed as:
y = a + [alpha]k + [beta]g + [gamma]m, (1)
where y is growth, k is private capital, g is public expenditure, and m is money supply. It also includes other aspects that could affect growth, such as openness or technological level, but are not directly included in the equation
Private capital, k, would depend on:
k = [zeta]cf - [lambda]i + [micro]y - T + [xi], (2)
where cf is cash flow, i is the interest rate, T is the tax rate, and [xi] is business expectations.
In the previous section, cash flow had been defined as the difference between the collections and the payments of the firm. An approximate form to define collections considers price and sales. Price depends on the economic activity (demand and supply evolution) and monetary policy design. The sales (q) would depend on:
q = f(t,d,[theta]), (3)
where t is the state of technology, d is product demand, and [theta] includes other factors such as consumer taste.
Regarding payments (p):
p = f(i,w,[eta]), (4)
where w is production cost and [eta] includes other aspects such as the difficulty of obtaining credit.
The public expenditure (g) would be divided in the following way:
g = [g.sub.c] + [g.sub.i] = Ty, (5)
where [g.sub.c] is the average public expenditure and [g.sub.i] is public investment. One can consider the neoclassical assumption that the public budget is balanced in the long-term, so public expenditure will be financed by taxes, T being the tax rate, and taxes depend on the rent.
To simplify the analysis, it is assumed that the monetary authority can control the money supply. Therefore, in this group of equations, the effects on the fiscal and monetary policies on economic growth are checked. Regarding the former, a higher public expenditure will improve growth directly in accordance with (1). But there would also be indirect effects. According to (3), there would be a larger quantity of product sold, given that higher demand would positively affect the cash flow. According to (2), a higher cash flow will improve private capital, which would help increase the economy.
On the negative side, one has to consider first of all that an increase in public expenditure must be financed in the long-term by higher taxes. If businesses foresee this circumstance, they may be less interested to invest (1).
Secondly, the increase of public expenditure would propitiate a demand inflation, that would positively affect the cash flow through higher revenues. On the other hand, the payments would increase. According to (4), [omega] would increase because workers would want to maintain their real wages and other productive factors would also be more costly. Depending on trade, union power, [omega] could be increased in great measure, compensating and even eliminating the positive effect.
On the other hand, monetary policy would affect economic growth in the following three ways. The first is directly, since an increment of m would improve economic growth [Fry, 1995] (equation 1). Second, following Khan and Villanueva  through the interest rate alterations (equation 2), and third, one has to consider the credit institutions paper (equation 4) as indicated in the previous section.
Therefore, taking into account this group of relationships, one can consider the monetary policy effects on economic growth. For example, an increase in the money supply would have the following effects.
1) A direct increase of growth, as expressed in (1).
2) A reduction of the type of interest, which would positively affect investment and ultimately, economic growth.
3) A reduction in the interest rate would also result in the reduction of payments.
4) It would be necessary to add to the previous point that an interest rate reduction could encourage families to finance durable goods through debt, causing firm collections to increase (equation 3). In definitive, points 3 and 4 would suppose a higher cash flow, with a corresponding positive effect on [kappa] and ultimately on economic growth.
5) From a different point of view, it would also be necessary to consider the effect on prices. Higher prices would compensate for the previous positive effects on cash flow.
Obviously, the effects that have been pointed out are susceptible to alterations, since it is necessary to include the behavior of social variables, as well as to consider how the design of the policy could influence business expectations that would impact [kappa] (equation 2). (2)
This paper has analyzed the effects of cash flow on economic growth. It has shown how monetary and fiscal policies would directly and indirectly influence cash flow. Different equations were developed to allow one to consider cash flow in the economic growth process. Further study should incorporate other types of performance, such as institutional, social character, or distribution, which would help to improve our knowledge of the mechanics of growth.
(1.) See equation (2).
(2.) To improve this analysis, it could be possible to include the relationship between the firm's yields and cash flow. See Dechow, Kothari, and Watts .
Dechow, P. M; Kothari, S. P; Watts, R. L. "The Relation Between Earnings and Cash Flows," Journal of Accounting and Economics, 25, 1998, Pp. 133-168.
Deininger, K.; Squire, L. "New Ways of Looking at Old Issues: Inequality and Growth," Journal of Development Economics, 57, 1998, pp. 259-287.
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Gonzalez Minguez, J. M. "The Balance-Sheet Transmission Channel of Monetary Policy: The Case of Germany and Spain," Banco de Espana, Servicio de Estudios, Working Paper, 9713, Madrid, 1997.
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Khan, M. S.; and Villanueva, D. "Macroeconomic Policies and Long-Term Growth: A Conceptual and Empirical Review," International Monetary Fund, working paper/92/28, marzo, Washington.
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* University of Castilla-La Mancha and University Complutense of Madrid-Spain
Maria-Teresa Mendez Picazo *…