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

58 Pages Posted: 14 May 2009  

Kaiji Chen

Emory University - Department of Economics; Federal Reserve Bank of Atlanta

Zheng Michael Song

Fudan University - School of Economics

Date Written: April 14, 2009

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

JEL Classification: E32, G34

Suggested Citation

Chen, Kaiji and Song, Zheng Michael, Financial Frictions on Capital Allocation: A Transmission Mechanism of TFP Fluctuations (April 14, 2009). Available at SSRN: https://ssrn.com/abstract=1403844 or http://dx.doi.org/10.2139/ssrn.1403844

Kaiji Chen (Contact Author)

Emory University - Department of Economics ( email )

1602 Fishburne Drive
Atlanta, GA 30322
United States

HOME PAGE: http://https://sites.google.com/site/chenkaiji/research

Federal Reserve Bank of Atlanta ( email )

1000 Peachtree Street N.E.
Atlanta, GA 30309-4470
United States

Zheng Song

Fudan University - School of Economics ( email )

600 GuoQuan Road
Shanghai, 200433
China

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