Financial Markets, Creation and Liquidation of Firms and Aggregate Dynamics

Alexander Monge-Naranjo

No 1648, Econometric Society World Congress 2000 Contributed Papers from Econometric Society

Abstract: The evidence indicates that small and young firms respond differently to shocks in the financial markets than larger, older firms. Moreover, gross job flows indicate that the differences are mostly in the activation and liquidation decisions. In this dissertation we examine the impact of shocks that affect the economy via the interest rates and explore the transmission on the cross-section of active firms. In the model, due to the limited commitment of entrepreneurs, credit constraints arise endogenously. The solution of the optimal infinite horizon contract between banks and firms turns out to be very simple. Initially firms accumulate net worth as fast as possible and their size and survival probabilities grow over time. We provide a decentralization in which entrepreneurs trade in one-period securities, rationalizing solvency and borrowing constraints and making it natural to link the collateral of the entrepreneur with the size and age of the firm. The results are consistent with observed entry and exit behavior. The larger the collateral of firms, the less sensitive to interest rates is the exit probability, i.e. small, younger firms are more sensitive to interest rates than that of larger, more mature firms. With respect to entry, with higher interest rates, less firms are created, and a higher productivity is needed for activation, purifying the pool of entrants and increasing future survival. However, given their characteristics, firms created during recessions face tighter credit constraints and have lower survival probabilities. The model is qualitatively consistent with the evidence. Real interest rates comove negatively with aggregate output, gross creation, net growth, of jobs and firms, and positively with flows of job and firm destruction. With the frictions in the creation of firms, the model also compatible with the volatility of destruction flows being much larger than that of creation flows. The response in the mass of active firms provides a propagation mechanism. Output dynamics is asymmetric as recessions are shorter than expansions. Additionally, the destruction series are highly concentrated in short periods of times.

Date: 2000-08-01
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