Financial Frictions on Capital Allocation: A Transmission Mechanism of TFP Fluctuations

Kaiji Chen () and Zheng Michael Song ()

MPRA Paper from University Library of Munich, Germany

Abstract: This paper provides a theory of financial frictions as a transmission mechanism for primitive shocks to translate into aggregate TFP fluctuations. In our model, financial frictions distort existing capital allocation across different production units, rather than investment in new capital. News shocks on future technology improvement are introduced as a device to identify TFP fluctuations originating from this mechanism. Our simulation shows that variations in financial frictions in response to news shocks can generate sizable fluctuations in aggregate TFP and, thus, business cycles before the actual technology change is realized. Using a combined dataset from Compustat and IBES, we find that the empirical responses of capital acquisition to prospects about future profitability are significantly larger for firms more likely to be financially constrained, while such a pattern does not exist for new capital investment. Furthermore, capital acquisition of constrained firms is found to be more procyclical than that for unconstrained ones. Our evidence thus provides strong support for the importance of financial frictions on capital allocation as the transmission mechanism proposed by our theory.

Keywords: Financial Friction; Capital Reallocation; TFP Fluctuation; News Shock (search for similar items in EconPapers)
JEL-codes: E32 G34 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-bec and nep-mac
Date: 2009-04-14
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Persistent link: http://EconPapers.repec.org/RePEc:pra:mprapa:15211

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