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Financial Frictions on Capital Allocation: A Transmission Mechanism of TFP Fluctuations

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  • Chen, Kaiji
  • Song, Zheng

Abstract

This paper provides a theory of financial frictions as a transmission mechanism for primitive shocks to translate into aggregate TFP fluctuations. In our model, financial frictions distort existing capital allocation across different production units, rather than investment in new capital. News shocks on future technology improvement are introduced as a device to identify TFP fluctuations originating from this mechanism. Our simulation shows that variations in financial frictions in response to news shocks can generate sizable fluctuations in aggregate TFP and, thus, business cycles before the actual technology change is realized. Using a combined dataset from Compustat and IBES, we find that the empirical responses of capital acquisition to prospects about future profitability are significantly larger for firms more likely to be financially constrained, while such a pattern does not exist for new capital investment. Furthermore, capital acquisition of constrained firms is found to be more procyclical than that for unconstrained ones. Our evidence thus provides strong support for the importance of financial frictions on capital allocation as the transmission mechanism proposed by our theory.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 15211.

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Date of creation: 14 Apr 2009
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Handle: RePEc:pra:mprapa:15211

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Keywords: Financial Friction; Capital Reallocation; TFP Fluctuation; News Shock;

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Cited by:
  1. Paul Beaudry & Franck Portier, 2013. "News Driven Business Cycles: Insights and Challenges," NBER Working Papers 19411, National Bureau of Economic Research, Inc.
  2. Jennifer La'O, 2010. "Collateral Constraints and Noisy Fluctuations," 2010 Meeting Papers 780, Society for Economic Dynamics.
  3. repec:fip:fedreq:y:2011:i:3q:p:209-254:n:vol.97no.3 is not listed on IDEAS
  4. Enrique G. Mendoza & Javier Bianchi, 2011. "Overborrowing, Financial Crises and ‘Macro-Prudential’ Policy?," IMF Working Papers 11/24, International Monetary Fund.
  5. Lei Fang, 2010. "Entry cost, financial friction, and cross-country differences in income and TFP," Working Paper, Federal Reserve Bank of Atlanta 2010-16, Federal Reserve Bank of Atlanta.
  6. Javier Bianchi & Enrique G. Mendoza, 2010. "Overborrowing, Financial Crises and 'Macro-prudential' Taxes," NBER Working Papers 16091, National Bureau of Economic Research, Inc.
  7. Christoph Görtz & John D. Tsoukalas, 2013. "Sector Specific News Shocks in Aggregate and Sectoral Fluctuations," CESifo Working Paper Series 4269, CESifo Group Munich.
  8. Lei Fang, 2010. "Entry Barriers, Financial Frictions, and Cross-Country Differences in Income and TFP," 2010 Meeting Papers 505, Society for Economic Dynamics.
  9. Javier Bianchi & Enrique G. Mendoza, 2011. "Overborrowing, Financial Crises and 'Macro-prudential' Policy," 2011 Meeting Papers 175, Society for Economic Dynamics.
  10. Kaiji Chen & Edouard Wemy, 2014. "Investment-Specific Technology Shocks: The Source of Anticipated TFP Fluctuations," Emory Economics, Department of Economics, Emory University (Atlanta) 1401, Department of Economics, Emory University (Atlanta).
  11. Vincenzo Quadrini, 2011. "Financial frictions in macroeconomic fluctations," Economic Quarterly, Federal Reserve Bank of Richmond, Federal Reserve Bank of Richmond, issue 3Q, pages 209-254.

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