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Identifying Aggregate Shocks with Micro-level Heterogeneity: Financial Shocks and Investment Fluctuation

Xing Guo

Staff Working Papers from Bank of Canada

Abstract: This paper identifies aggregate financial shocks and quantifies their effects on business investment based on an estimated DSGE model with firm-level heterogeneity. On average, financial shocks contribute only 3% of the variation in U.S. public firms’ aggregate investment. The negligible aggregate relevance of financial shocks mainly results from the interaction between firm-level heterogeneity and general equilibrium effects. Following a contractionary financial shock, financially constrained firms are directly forced to cut investment, which dampens the aggregate investment demand and lowers the price of capital good. A lower capital good price motivates the financially unconstrained firms to invest more, which largely cancels out the financial shock’s direct effect on aggregate. If I abstract from firm-level heterogeneity, the implied relevance of financial shocks to aggregate investment is 15 times larger. This sharp difference indicates that representative firm models could overstate the relevance of financial shocks in driving the business cycle fluctuations, and highlights the important role played by the interaction between of micro-level heterogeneity and general equilibrium effects in shaping the transmission of aggregate shocks.

Keywords: Business fluctuation and cycles; Firm dynamics (search for similar items in EconPapers)
JEL-codes: E22 G32 (search for similar items in EconPapers)
Pages: 49 pages
Date: 2020-05
New Economics Papers: this item is included in nep-dge, nep-fdg and nep-mac
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