Final Report Summary - FINMIS (Financial Development, Factor Misallocation and Total Factor Productivity)
The main objective of this grant project has been to develop novel theories to investigate the interactions between financial market imperfections, firms’ performance and aggregate economic activity. Specifically, by building structural heterogeneous firm models, the first goal of the project was to provide a set of theoretical conjectures concerning the interactions between firms’ investment and technology dynamics and company balance sheet conditions on the one hand; and the interactions between macroeconomic economic performance and indicators of aggregate financial market efficiency on the other hand. The second goal of the project is, using firm-level and macroeconomic data from various countries, to quantify the benefits of financial development by exploring the improvements that financial development leads to in firms’ investment and technology efficiency, and understand the macroeconomic implications of firm behaviour when financial markets function imperfectly. This “micro-to-macro” approach allows to develop and test underlying theoretical relationships that are simultaneously consistent with firm-level as well as aggregate empirical relations between finance and economic activity.
The main conclusions of this project are as follows:
- Opportunities for entrepreneurs to accumulate wealth can mitigate the implications of limited enforceability on resource misallocation, productivity and macroeconomic development: Using a dynamic general equilibrium model, I show that the financially constrained entrepreneurs select short-term investment projects because short-term investment enhances net-worth building and relaxes credit constraints. The limited contract enforceability suppresses macroeconomic output; however, entrepreneurial net-worth building offsets the per-capita income losses. The counterfactual simulations based on this model reveal that net-worth building could reduce, for instance, about 2/3 of the per-capita income discrepancy between the U.S. and Brazil that can be attributed to limited enforcement.
- Using a model of misallocation, I show that weakening the observed balance sheet positions for financially constrained firms leads to a reallocation of production factors from firms with high cost distortions to firms with low cost distortions and causes quantitatively important industry level TFP losses.
- Using another model of misallocation, I investigate the implications of two distinct notions of flexibility in curbing capital market imperfections: (i) the firm-specific ability to optimize over a set of production techniques that serve to organize capital and labor; and, (ii) the industry-specific substitutability between efficient units of capital and labor. Applying the micro-founded structure to data shows that for a broad range of U.S. manufacturing industry clusters, technique misallocation generates more TFP losses than capital misallocation, with larger TFP gains from removing technique misallocation in industries using more flexible production technologies.
- Flexibility of production matters for competitiveness. Production flexibility explains the industry dynamics in Taiwanese Foundry industry and financially constrained small firms respond to shocks. The results indicate that high production flexibility, estimated at the firm level using a unique dataset, allows unproductive firms to compete with their productive counterparts.
- Unbundling financial market imperfections reveals potential counterproductive effects of financial market imperfections on firms’ investment and aggregate economic performance. Specifically, I develop a dynamic general equilibrium model of occupation choice to isolate the macroeconomic consequences of lending frictions from that of trading frictions in a framework, where long-term entrepreneurial investment is the engine of the macroeconomic activity. In stationary equilibria, while financial deepening through better ability to lend is always welfare improving, financial deepening stimulated by trading could be detrimental to the society’s entrepreneurial investment. I illustrate that a model qualitatively consistent with the U.S. financial development episode of the last 30 years should exhibit disproportionately large reductions in trading frictions relative to lending frictions.
This grant research project shed light on the fact that firms respond to financial market imperfections by altering their investment and technology adoption decisions to enhance their profitability and competitive margins. By how much they would choose to do so is usually related to their balance sheet characteristics and flexibility of production lines. Macroeconomic financial development policies which do not take such micro-founded firm-level adjustments into account are likely to be counterproductive.
The main conclusions of this project are as follows:
- Opportunities for entrepreneurs to accumulate wealth can mitigate the implications of limited enforceability on resource misallocation, productivity and macroeconomic development: Using a dynamic general equilibrium model, I show that the financially constrained entrepreneurs select short-term investment projects because short-term investment enhances net-worth building and relaxes credit constraints. The limited contract enforceability suppresses macroeconomic output; however, entrepreneurial net-worth building offsets the per-capita income losses. The counterfactual simulations based on this model reveal that net-worth building could reduce, for instance, about 2/3 of the per-capita income discrepancy between the U.S. and Brazil that can be attributed to limited enforcement.
- Using a model of misallocation, I show that weakening the observed balance sheet positions for financially constrained firms leads to a reallocation of production factors from firms with high cost distortions to firms with low cost distortions and causes quantitatively important industry level TFP losses.
- Using another model of misallocation, I investigate the implications of two distinct notions of flexibility in curbing capital market imperfections: (i) the firm-specific ability to optimize over a set of production techniques that serve to organize capital and labor; and, (ii) the industry-specific substitutability between efficient units of capital and labor. Applying the micro-founded structure to data shows that for a broad range of U.S. manufacturing industry clusters, technique misallocation generates more TFP losses than capital misallocation, with larger TFP gains from removing technique misallocation in industries using more flexible production technologies.
- Flexibility of production matters for competitiveness. Production flexibility explains the industry dynamics in Taiwanese Foundry industry and financially constrained small firms respond to shocks. The results indicate that high production flexibility, estimated at the firm level using a unique dataset, allows unproductive firms to compete with their productive counterparts.
- Unbundling financial market imperfections reveals potential counterproductive effects of financial market imperfections on firms’ investment and aggregate economic performance. Specifically, I develop a dynamic general equilibrium model of occupation choice to isolate the macroeconomic consequences of lending frictions from that of trading frictions in a framework, where long-term entrepreneurial investment is the engine of the macroeconomic activity. In stationary equilibria, while financial deepening through better ability to lend is always welfare improving, financial deepening stimulated by trading could be detrimental to the society’s entrepreneurial investment. I illustrate that a model qualitatively consistent with the U.S. financial development episode of the last 30 years should exhibit disproportionately large reductions in trading frictions relative to lending frictions.
This grant research project shed light on the fact that firms respond to financial market imperfections by altering their investment and technology adoption decisions to enhance their profitability and competitive margins. By how much they would choose to do so is usually related to their balance sheet characteristics and flexibility of production lines. Macroeconomic financial development policies which do not take such micro-founded firm-level adjustments into account are likely to be counterproductive.