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

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Author Info
Chen, Kaiji
Song, Zheng

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

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Find related papers by JEL classification:
E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance

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