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External Financing and the Role of Financial Frictions over the Business Cycle: Measurement and Theory

Author

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  • Ariel Zetlin-Jones
  • Ali Shourideh

    (University of Pennsylavnia)

Abstract

We examine the quantitative importance of financial market shocks in accounting for business cycle fluctuations. We emphasize the role financial markets play in reallocating funds from cash-rich, low productivity firms to cash-poor, high productivity firms. We use evidence on financial flows to analyze the importance of this role of financial markets. This evidence shows that in the aggregate, funds available to firms internally are more than adequate to finance investment. At the firm level, we find that for publicly traded firms (in Compustat), almost all investment is financed internally while, using a alternative data source (Amadeus), we find that most investment by privately held firms is financed through borrowing. These observations suggest that the quantitative impact of financial market shocks depend both on the sensitivity of investment and output of privately held firms to such shocks and on the extent to which the investment and output of publicly held firms respond to the actions of privately held firms. Motivated by these observations, we build a quantitative model featuring publicly and privately held firms that face collateral constraints and idiosyncratic risk over productivity. We model financial market shocks as shocks to the collateral constraints. In our model, each firm has a monopoly in producing a differentiated good and uses the goods produced by other firms as an input for production -- features that create non-financial linkages between publicly and privately held firms. In our calibrated model, we find that a shock to the collateral constraints which generates a one standard deviation decline in the debt-to-asset ratio leads to a 0.5% decline in aggregate output on impact, roughly comparable to the effect of a one standard deviation shock to aggregate productivity in a standard real business cycle model. In this sense, we find that disturbances in financial markets are a promising source of business cycle fluctuations when non-financial linkages across firms are sufficiently strong.

Suggested Citation

  • Ariel Zetlin-Jones & Ali Shourideh, 2012. "External Financing and the Role of Financial Frictions over the Business Cycle: Measurement and Theory," 2012 Meeting Papers 321, Society for Economic Dynamics.
  • Handle: RePEc:red:sed012:321
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    6. Marco Bassetto & Marco Cagetti & Mariacristina De Nardi, 2015. "Credit Crunches and Credit Allocation in a Model of Entrepreneurship," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 18(1), pages 53-76, January.
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    10. Saki Bigio, 2013. "Financial Frictions in Production Networks," 2013 Meeting Papers 121, Society for Economic Dynamics.
    11. Florian Gerth, 2017. "Allocative efficiency of UK firms during the Great Recession," Studies in Economics 1714, School of Economics, University of Kent.
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    13. Chiu, Ching-Wai (Jeremy) & Mumtaz, Haroon & Pinter, Gabor, 2016. "VAR models with non-Gaussian shocks," LSE Research Online Documents on Economics 86238, London School of Economics and Political Science, LSE Library.
    14. Josef Schroth, 2016. "Financial Crisis Interventions," Staff Working Papers 16-29, Bank of Canada.
    15. Quadrini, Vincenzo, 2014. "Bank Liabilities Channel," CEPR Discussion Papers 10265, C.E.P.R. Discussion Papers.
    16. Veracierto, Marcelo, 2014. "Adverse Selection, Risk Sharing and Business Cycles," Working Paper Series WP-2014-10, Federal Reserve Bank of Chicago.
    17. Ercolani, Valerio & Valle e Azevedo, João, 2014. "The effects of public spending externalities," Journal of Economic Dynamics and Control, Elsevier, pages 173-199.
    18. Saki Bigio & Jennifer La’O, 2016. "Financial Frictions in Production Networks," Working Papers 2016-67, Peruvian Economic Association.
    19. Andrea L. Eisfeldt & Tyler Muir, 2014. "Aggregate External Financing and Savings Waves," NBER Working Papers 20442, National Bureau of Economic Research, Inc.
    20. Lubik, Thomas A. & Sarte, Pierre-Daniel G. & Schwartzman, Felipe, 2014. "What Inventory Behavior Tells Us About How Business Cycles Have Changed," Working Paper 14-6, Federal Reserve Bank of Richmond.
    21. Paul Bergin & Ling Feng & Ching-Yi Lin, 2014. "Financial Frictions and Firm Dynamics," NBER Working Papers 20099, National Bureau of Economic Research, Inc.
    22. Di Nola, Alessandro, 2015. "Capital Misallocation during the Great Recession," MPRA Paper 68289, University Library of Munich, Germany.
    23. Francisco J. Buera & Benjamin Moll, 2012. "Aggregate Implications of a Credit Crunch," NBER Working Papers 17775, National Bureau of Economic Research, Inc.
    24. Sarte, Pierre-Daniel & Schwartzman, Felipe & Lubik, Thomas A., 2015. "What inventory behavior tells us about how business cycles have changed," Journal of Monetary Economics, Elsevier, pages 264-283.
    25. Siemer, Michael, 2014. "Firm Entry and Employment Dynamics in the Great Recession," Finance and Economics Discussion Series 2014-56, Board of Governors of the Federal Reserve System (U.S.).

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