Investment and Capital Reallocation

Wei Cui (Bendheim Center for Finance)
Monday, November 7, 2011 - 2:00pm
Sandauer Strasse 1, Room 22

Financial constraints on firms have recently obtained a wide recognition in macroeconomics since the recent crisis. But there is still a debate on the power of these financial constraints in generating large financial frictions and in amplifying total factor productivity (TFP) shocks. Here we argue that collateral constraint and small asymmetric information in the capital resale market can lead to powerful financial frictions. A two-sector dynamic model is introduced, with investment and capital reallocation. The capital reallocation market is imperfect due to financial constraints on some firms and the information asymmetry in the resale market. In such an economy, the dynamic interaction among asset price, new investment and the quality of the resale capital pool, is a powerful mechanism that extends small temporary TFP shocks. However, temporary shocks will quickly dampen if the economy has only financial constrained firms and no information problem in the resale market. Finally, the policy implication is that, if the capital resale market is subject to asymmetric information so that new investment has positive externalities improving average quality of resale capital, investment in new capital should be subsidized.