Working Paper: NBER ID: w20099
Authors: Paul Bergin; Ling Feng; Chingyi Lin
Abstract: Firm entry dynamics are an integral part of the propagation of financial shocks to the real economy. A VAR documents that adverse financial shocks in the U.S. postwar period are associated with a fall in new firm creation and a fall in firm equity values. We propose a DSGE model with endogenous firm entry and financial frictions that is able to explain these facts. The model is novel in giving firms a choice of financing up-front entry costs through a combination of debt as well as equity, so that financial shocks directly impact the financing of firm entry. The model is also novel in making use of the asset pricing implications of the firm entry condition to explain the equity price response to a financial shock. The model indicates that free entry of new firms limits the ability of incumbent firms to respond to negative financial shocks through endogenous capital restructuring. Also, allowing the number of firms to fall after an adverse financial shock is a useful margin of macroeconomic adjustment, reducing the overall impact of the shock on aggregate output. This is because the remaining firms become financially stronger and better able to withstand a financial shock.
Keywords: Financial Frictions; Firm Dynamics; Financial Shocks; Firm Entry
JEL Codes: E32; E44; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increase in cost of borrowing (G21) | Decrease in new firm creation (L26) |
| Adverse financial shock (E44) | Decrease in new firm creation (L26) |
| Adverse financial shock (E44) | Decline in equity values (G12) |
| Adverse financial shock (E44) | Fall in firm creation (L26) |
| Adverse financial shock (E44) | Immediate decline in equity prices (G19) |
| Free entry of new firms (L17) | Limits ability of incumbent firms to respond to negative financial shocks (G32) |
| Decrease in new firm creation (L26) | Reduces overall impact of the shock on aggregate output (E19) |