Collateral constraints, capital specificity and the distribution of production: the role of real and financial frictions in aggregate fluctuations

We study the cyclical implications of credit market imperfections in a dynamic, stochastic general equilibrium model wherein firms face persistent shocks to both aggregate and individual productivity. In our model economy, optimal capital reallocation is distorted by two frictions. First, collateralized borrowing constraints limit the investment undertaken by small firms with relatively high productivities. Second, a quasi-specificity in firm-level capital implies investment irreversibilities that lead firms to pursue generalized (S,s) investment rules. This second friction compounds the first in implying that large and relatively unproductive firms carry a disproportionate share of the aggregate capital stock, thereby reducing endogenous aggregate total factor productivity. Moreover, because irreversibilities not only directly induce both downward and upward inertia in firm-level capital adjustment, but also tighten the borrowing limits associated with collateral constraints, they ensure that the negative consequences of a temporary tightening in financial markets are not quickly repaired. In the presence of persistent heterogeneity in both capital and total factor productivity, the effects of a financial shock can be amplified and propagated through large and long-lived disruptions to the distribution of capital that, in turn, imply large and persistent reductions in aggregate total factor productivity. Similarly, the consequences of a negative real shock can be exacerbated and prolonged in the presence of real and financial frictions. This paper seeks to measure the strength of these effects in a calibrated DSGE setting.