Financial frictions drive 30% of TFP variance in cycles
A new Federal Reserve Board working paper introduces a tractable model showing that financial frictions account for about 30 percent of aggregate total factor productivity variance at business-cycle frequencies. This endogenous component is significantly influenced by strategic default among firms.
Productivity dispersion in downturns
Within narrowly defined industries, the most productive firms produce far more than the least productive from the same inputs, and this dispersion widens in downturns.
This paper builds a tractable representative-agent model where financial frictions, specifically adverse selection and moral hazard, cause firms to sort into lenders, strategic defaulters, and producers.
As credit conditions fluctuate, the resulting misallocation creates an endogenous component of aggregate total factor productivity (TFP).
This component accounts for approximately 30 percent of the variance of TFP at business-cycle frequencies, with one-third of this contribution stemming from strategic default.
The model successfully matches key features of observed productivity distribution across firms and its co-movement with output growth and credit conditions in the data.
Strategic default's dual purpose
The model's appeal lies in its tractability, capturing capital misallocation through just a few objects: two productivity cutoffs and the inter-firm interest rate.
These boundaries shift with aggregate conditions, and the changing composition of producing firms is all the aggregate economy needs to track.
This allows embedding the mechanism in standard business-cycle models with minimal additional equations.
The framework also captures strategic default as an equilibrium outcome.
This equilibrium variation in defaulting firms is quantitatively important, accounting for roughly one-third of the endogenous TFP component.
It amplifies the endogenous TFP component and stabilizes its dynamic path by distributing reallocation across two margins rather than concentrating it in a single threshold.
A tractable lens on TFP
This paper offers a significant step forward by providing a tractable model that links financial frictions to endogenous TFP dynamics.
Its ability to integrate strategic default as an equilibrium outcome, rather than an exogenous shock, is particularly insightful.
For policymakers, this framework provides a clearer understanding of how credit conditions can impact aggregate productivity, offering a new tool for business-cycle analysis.