We draw on stylized facts from the finance literature to build a model where altering the relative costs of bank and bond financing changes the entire distribution of firm size, with implications for the aggregate capital stock, output, and welfare. Reducing transactions costs in the bond market increases the output and profits of mid-sized firms at the expense of both the largest and smallest firms. In contrast, reducing the frictions involved in bank lending promotes the expansion of the smallest firms while all other firms shrink, even as it increases the profitability of both small and mid-size firms. Although both policies increase aggregate output and welfare, they have opposite effects on the extensive margin of production-promoting bond issuance causes exit while cheaper bank credit induces entry. When reducing transactions costs in one market, the resulting increase in output and welfare are largest when transactions costs in the other market are very high.
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Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number
2009-25.