Uncertainty, Incentives, and Misallocation

This paper identifies a new propagation mechanism by which the effects of business cycle shocks amplify in the context of the dynamic stochastic general equilibrium framework. Business cycle shocks, such as heightened uncertainty, and positive monetary shocks endogenously magnify the cross‐sectional dispersion in idiosyncratic productivity. This induces entrepreneurs, who have asset substitution incentive, to distort the quality of an investment project, which amplifies the response of investment and output. Moreover, lenders reallocate credit from firms with a high marginal product of capital, in which the asset substitution problem is more prevalent, to firms with a low marginal product of capital, which in turn further depresses aggregate economic activities. A policy that subsidizes lenders to firms with a high marginal product during a recession improves the allocation of loans. Empirical evidence from the NBER‐CES Manufacturing Industry Database provides support for the model's predictions.