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

This paper provides a theory of \u85nancial frictions as a transmission mechanism for prim-itive shocks to translate into aggregate TFP uctuations. In our model, \u85 nancial frictions distort existing capital allocation across di¤erent production units, rather than investment in new capital. News shocks on future technology improvement are introduced as a device to identify TFP uctuations originating from this mechanism. Our simulation shows that variations in \u85nancial frictions in response to news shocks can generate sizable uctuations in aggregate TFP and, thus, business cycles before the actual technology change is realized. Using a combined dataset from COMPUSTAT and IBES, we \u85nd that the empirical re-sponses of capital acquisition to prospects about future pro\u85tability are signi\u85cantly larger for rms more likely to be \u85nancially constrained, while such a pattern does not exist for new capital investment. Furthermore, capital acquisition of constrained \u85rms is found to be more procyclical than that for unconstrained ones. Our evidence thus provides strong support for the importance of \u85nancial frictions on capital allocation as the transmission mechanism proposed by our theory