Production Heterogeneity, the Allocation of Credit, and Aggregate Fluctuations

Ohio State University, The, Columbus OH

Investigators

Abstract

Abstract for NSF Proposal 1061859 The most recent U.S. recession has revitalized interest in business cycle research, while simultaneously challenging the predictions of existing macroeconomic models that abstract from differences across firms in aspects such as their productivity, capital, inventories and debt. Such rich differences may be important toward reconciling the empirical observation that the mean firm in the U.S. economy does not need to borrow to finance its investment with the widespread view that changes in the availability of credit had an important influence on the 2007 - 2009 recession. This proposal explores the relation between production heterogeneity, discrete choices and aggregate fluctuations. The project seeks to develop and examine quantitative dynamic stochastic general equilibrium models to better understand the mechanics of economic fluctuations following real and financial shocks, and the role of inventories at various stages of the business cycle. At the heart of both parts of the proposal are macroeconomic models with rich heterogeneity across firms with respect to productivity, capital, inventories and debt. Such heterogeneity implies a multi-dimensional distribution of firms that affects the aggregate state of the economy, and thus economic fluctuations. The recent real and financial crisis in the U.S. and abroad has driven researchers to try to integrate financial factors into standard models commonly used to study aggregate fluctuations. Before now, there has been little quantitative research on the channels through which changes in the availability of credit influence macroeconomic aggregates like business investment and production in a fully articulated setting. Project 1, Credit shocks and aggregate fluctuations in an economy with production heterogeneity, is unique in its approach to the topic, deriving an endogenous productivity channel through which changes in the allocation of credit can influence aggregate dynamics in an environment where firms differ in their productivities, capital, and debt. Existing research has generally abstracted from the rich heterogeneity across firms evident in microeconomic data. This is an important omission if such heterogeneity affects the evolution of macroeconomic variables. By contrast, this project explicitly includes a real friction hindering capital reallocation across firms in a setting with persistent productivity heterogeneity to reproduce salient micro-level investment patterns. Taken alongside collateralized borrowing arrangements, these elements imply a rich distribution of firms shaping total production, investment, and employment. That distribution evolves slowly in response to aggregate shocks, and itself protracts the economy's overall response to such shocks. Inventory investment is highly volatile, both in business cycles and at higher frequencies. However, the series behaves quite differently over the two frequency bands. It moves positively with final sales at business cycle frequencies, while it moves negatively with sales over the short term. These conflicting patterns represent a challenge for existing micro-founded models of inventories. Project 2, Inventories, idiosyncratic shocks, and aggregate fluctuations, seeks to overcome the challenge. This project works to develop a single parsimonious DSGE model that can accommodate both sets of regularities when its parameters are disciplined by aggregate and firm-level data and inventory decision rules are endogenously derived as the result of an (S,s) motive. An increased understanding of the ways in which real and financial frictions shape the distributions of productive inputs in modern developed economies, alongside the ways in which such distributions affect aggregate responses to real and financial shocks, will deepen policymakers' understanding of economic fluctuations. This, in turn, will help them to better anticipate the stages of the business cycle and to more effectively evaluate the need for various policy prescriptions and weigh the relative merits of competing policies. Preliminary findings in Project 1 indicate that the evolution of the distribution of firms following a credit shock can cause a large, gradual decline in economic activity and slow subsequent recovery. The model predicts clear differences in the responses of GDP and other macroeconomic variables following a credit shock versus a nonfinancial shock, and thus may offer policymakers a valuable tool. By distinguishing the responses to shocks, it can help identify the primary source of a recession and thus help them to determine which, if any, policies should be implemented to best promote economic growth and stabilization. Analysts and policymakers place enormous emphasis on inventory investment as signal of economic conditions. There is no micro-founded quantitative business cycle model simultaneously consistent with the short-term and business cycle behavior of inventories for use in policy analysis as yet. Project 2 is an effort to correct this problem. Its successful completion will expand policymakers' ability to interpret ongoing movements in inventories and their understanding of how they influence and predict movements in other key macroeconomic series.