Monetary policy shocks and precautionary cash in Europe

Theories of corporate liquidity demand build on the notion that firms accumulate cash to safeguard their activities in the face of costly external finance. Positive monetary shocks transmitted via the balance-sheet channel increase net worth, reduce the external finance premium and, arguably, demand for precautionary cash. This paper tests this proposition on a representative sample of euro-area firms using a high-frequency identification approach. I document that the ECB’s balance sheet shocks have heterogeneous effects on euro area firms’ cash holdings. High-collateral old firms respond to increased borrowing capacity by releasing cash, and then access borrowing to finance second-period investment. Young firms tend instead to hoard cash when credit conditions improve. My results indicate that the credit channel is alive in Europe and that financial frictions take predominantly the form of collateral constraints, which implies a significant exposure to central bank’s communication.