Production, Investment and Wealth Dynamics under Financial Frictions: An Empirical Investigation of the Selffinancing Channel

The ability of firms to accumulate wealth and build collateral is key to overcome financial frictions. The strength of this self-financing channel depends on the productivity process faced by firms and the parameters associated with the production function, and may be quantified by the elasticity of wealth accumulation to productivity shocks. We propose a framework to jointly estimate the production function, the productivity process, and the wealth accumulation process that is robust to financial frictions. We show that standard methods (e.g. Olley-Pakes) fail under financial frictions: they overestimate the labor elasticity and underestimate the capital elasticity of the production function, and underestimate the persistence and dispersion of the productivity process. We apply our method to the universe of Chilean firms and confirm these predictions, with factor elasticities varying around 25%, and productivity volatility more than doubling. We find evidence that is in line with the self-financing channel: (i) the reaction of investment to productivity shocks is contingent on the stock of collateral, with larger responses from unconstrained firms; (ii) highly productive firms accumulate wealth after positive and persistent productivity shocks, with a larger effect in wealthpoor firms.