Money demand function with time-varying coefficients

The objectives of this study are twofold; to explore the structural break(s) in the time series of the US firms’ cash ratio, and, to examine the sensitivity of cash to firm characteristics around the identified break point(s) using the time-varying coefficients model. We identify a major shift in cash ratio in 1995, in the middle of the longest NBER economic expansion. We attribute this changepoint to the large and unexpected change in the target federal funds rate in 1994–1995. Moreover, we find that cash flows exert a gradually decreasing positive effect on cash holdings in the pre-1995 era, followed by an increasing negative effect in the post-1995 era. We argue that this time series evidence can settle the debate on the cash-cash flow sensitivity in the literature. We further document a hump-shaped effect from market-to-book ratio on cash holdings with a turning point in 1995. Noting that 1995 is not the exclusive period displaying such a pattern, the recurring hump-shaped effect of market-to-book ratio complements previous findings on the cyclical feature of investment opportunities. Our findings are robust to the type of changepoint detector and alternative cash measures. The incidence of the changepoint amid economic boom highlights the need for additional research on firm cash holding decisions during periods of economic growth, as most previous studies focus on cash holding during periods of economic hardship.