Asset Pricing with Misallocation
72 Pages Posted: 10 Apr 2020 Last revised: 2 Jul 2021
Date Written: July 2, 2021
Misallocation reduces total factor productivity and economic growth, implying substantial adverse welfare effects. Misallocation measures should therefore provide a more informative empirical stochastic discount factor than aggregate consumption time series in small samples. We find evidence for misallocation-driven low-frequency movements in both aggregate growth and stock returns. We then develop an endogenous growth model with heterogeneous firms, intermediate goods, and financial frictions, in which misallocation emerges analytically as a crucial state variable. In equilibrium, misallocation endogenously generates long-run uncertainty about economic growth by distorting innovation and R&D decisions, leading to significant welfare losses and risk premia in capital markets. Empirically, a two-factor model with market and misallocation factors prices size, book-to-market, momentum, and bond portfolios with an R-squared and a mean absolute pricing error close to the Fama-French three-factor model.
Keywords: Agency conflicts, Distribution of firms, Financial frictions, Capital allocation, Endogenous growth, Asset pricing.
JEL Classification: L11, O30, O40.
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