Misallocation and Asset Prices

We develop an endogenous growth model with heterogeneous firms facing financial frictions, where misallocation emerges explicitly as a crucial endogenous state variable and plays a significant role in driving economic growth through the valuation channel. The model illustrates that transient macroeconomic shocks affecting misallocation can yield persistent effects on aggregate growth. In equilibrium, slow-moving misallocation endogenously generates long-run uncertainty about economic growth by distorting innovation decisions. When agents hold recursive preferences, misallocation-driven low-frequency growth fluctuations result in substantial risk premia in capital markets and large losses in consumer welfare. Employing a misallocation measure motivated by the model, we substantiate our findings with empirical evidence showing that misallocation effectively captures low-frequency fluctuations in both aggregate growth and asset returns.