Financial Intermediation and Capital Reallocation

Abstract

To understand the link between financial intermediation activities and the real economy, we build a general equilibrium model in which agency frictions in the financial sector affect the efficiency of capital reallocation across firms and generate aggregate economic fluctuations. We develop a recursive policy iteration approach to fully characterize the nonlinear equilibrium dynamics and the off-steady-state crisis behavior. In our model, adverse shocks to agency frictions exacerbate capital misallocation and manifest themselves as variations in total factor productivity at the aggregate level. Our model endogenously generates countercyclical volatility in aggregate time-series and countercyclical dispersion of marginal product of capital and asset returns in the cross-section.

Keywords: financial Intermediation, Capital Misallocation, Volatility, Crisis, Limited enforcement