This thesis examines the effects of financing frictions on corporate decisions using dynamic models. Accounting for financing frictions helps reconcile a number of regularities that are hard to explain within the Modigliani-Miller framework. For instance, financing frictions provide incentives for firms to keep liquidity on their balance sheets as a precautionary hedge---a pattern that has been heavily debated in light of the secular increase of cash-to-asset ratios of U.S. firms. The first chapter develops a model that investigates the relation between corporate policies and secondary stock market liquidity. I show that secondary market illiquidity limits a firm's ability to hold precautionary liquidity, exacerbates financial constraints, reduces investment, and decreases firm value. The model reproduces the positive relation between market liquidity and corporate cash holdings observed in the data. This relation might be surprising since firms with illiquid stocks, which have been documented to be more financially constrained than more liquid peers, should be willing to keep more precautionary cash. I also show that the illiquidity-driven drop in firm value can feed back into the secondary market by deterring the participation of liquidity providers, thereby making the market more illiquid. The self-reinforcing nature of this relation gives rise to an internal-external liquidity loop, which singles out a propagation mechanism between financial markets and the corporate sector. From a banking perspective, liquidity hoarding has been a hotly debated topic among academics and policy-makers in the aftermath of the 2007-2009 financial crisis. The second chapter, which is a joint work with Prof. Erwan Morellec and Marco Della Seta, develops a dynamic model of the effects of liability structure and liquid reserves on banks' insolvency risk. When a bank relies on short-term debt financing, negative operating shocks get amplified as the bank weaker fundamentals also translate into losses when rolling over short-term debt. This amplification mechanism leads to an increase in default risk that gets more pronounced as debt maturity decreases and rollover losses increase. Because of this amplification mechanism, banks with identical debt ratios and liquid reserves but different debt structures have different default risk. Heavy exposure to rollover risk can also lead banks to implement gambling strategies when close to default. The third chapter, which is a joint work with Prof. Semyon Malamud, analyzes firms' optimal policies in a general equilibrium setting. It characterizes optimal liquidity management, innovation, and production decisions for a continuum of firms facing financing frictions and the threat of creative destruction. We show that liquidity constraints lead firms to cut production and increase markups, which are then countercyclical with respect to firm-specific shocks. We also illustrate that liquidity constraints may spur firms' investment in innovation and give rise to a non-monotonic cash-investment relation. We embed our single-firm dynamics in a Schumpeterian model of endogenous growth and demonstrate that financing frictions have a non-monotonic effect on economic growth and may increase aggregate consumption. When the corporate sector is constrained, liquidity injections by the government have real effects and can stimulate growth.
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