What do information frictions do?

Summary. We present an overlapping generations model in which a labor market friction (moral hazard) coexists and interacts with a credit market friction (costly state verification). Our main results are: (i) while credit market frictions have long- and short-run real effects, labor market frictions typically have only short-run effects unless they also affect the volume of investment per worker, (ii) the frictions amplify each other to produce higher long-run unemployment than would result from only labor market frictions, (iii) these distortions may prolong the effect of temporary shocks, and (iv) the dynamics of economies with both frictions are qualitatively similar to their frictionless counterparts.Received: 25 February 2003, Revised: 1 April 2004, JEL Classification Numbers: E13, E24, O41, O17. Correspondence to: Joydeep BhattacharyaWork on this paper began while Bhattacharya was visiting the University of Texas at Austin and was completed when Chakraborty was visiting the IMF Institute in Washington, DC. We are grateful to both institutions for their hospitality. For helpful comments and suggestions we thank Valerie Bencivenga, Dean Corbae, Scott Freeman, Rajesh Singh, participants at the Macro Tea in Austin, and especially, an anonymous referee of this journal. The usual caveat applies.     

Product diffusion and pricing with market frictions

Summary. We study pricing and product diffusion in a dynamic general equilibrium framework with product market frictions. Ongoing R&D activity leads, with an endogenously determined probability, to continual improvements in product quality. We characterize the steady-state equilibrium with endogenous product diffusion in which a number of different goods co-exist on the quality ladder. We show that the severity of the economy's market frictions is a crucial determinant of the pricing structure, the product diffusion pattern, the level of R&D investment, the rate of endogenous growth, the length of Schumpeterian product cycles and the possibility of multiple growth paths. Eliminating market frictions leads to a degenerate product ladder of precisely one step, containing only the most recent product, as in the monopolistic competition literature. Received: August 16, 1999; revised version: March 6, 2001     

A solution to the hold-up problem involving gradual investment

We consider a setting in which the buyer's ability to hold up a seller's investment is so severe that there is no investment in equilibrium of the static game typically analyzed. We show that there exists an equilibrium of a related dynamic game generating positive investment. The seller makes a sequence of gradually smaller investments, each repaid by the buyer under the threat of losing further seller investment. As modeled frictions converge to zero, the equilibrium outcome converges to the first best. We draw connections between our work and the growing literature on gradualism in public good contribution games and bargaining games.     

Financial frictions and investment: requiem in Q

Understanding the nature of financial frictions faced by firms is relevant for both monetary and fiscal policy experiments. Empirical investment studies commonly find that proxies for firms' internal funds are significant as explanatory variables, particularly in the Q-theory based regression framework. These findings are often interpreted as evidence of financial frictions. This paper investigates that inference by specifying and estimating a class of dynamic optimization models where imperfectly competitive firms face financial constraints. Market power induces the principal link between investment and internal funds. We find no evidence to support the argument that capital market imperfections contribute to the relationship between investment and profitability.     

Staggered wages,financial frictions,and the international comovement problem

Standard international real business cycle models often generate negative cross-country correlations in labor and investment. The data, however, display positive correlations. This paper studies the effect of real wage rigidity and financial frictions on international comovement. We find that staggered wages mainly improve the cross-country correlation of labor, while financial frictions improve investment comovement. However, each friction alone cannot account for the magnitude of international correlations of either variable. When the two imperfections are introduced together, the effect of each friction endogenously reinforces the other and the model generates realistic correlations in both variables.     

Is ‘no news’ really ‘good news’? Country visibility and FDI location choice

In choosing where to invest, firms seek out information on a set of possible locations. Information asymmetries may make country visibility particularly important in decisions to locate investment abroad. We develop a country visibility index based on international news stories in The Economist, and show that broad country visibility is at least as important in attracting foreign direct investment (FDI) as other specific investment promotion activities or proxies for information frictions. Controlling for standard gravity model determinants of FDI, we find that greater visibility of developing countries, in particular lower middle- and low-income countries, increases the investment that they receive from US multinational corporations.     

Inventory investment and financial constraints in the Italian manufacturing industry: A panel data GMM approach

Three large unbalanced panels of Italian manufacturing firms observed over the period 1991–2009 are employed to assess, by means of a dynamic GMM approach, whether the existence of financial frictions is suitable to explain deviations of inventories from their long-run path. A negative response of inventory investment to the presence of financial burdens might provide evidence of a significant role played by the financial framework in conditioning the real side of the economy, especially during recession years, when liquidity problems arise. The negative effect is found over the entire analyzed period, with firms' dimensional aspects accounting more than risk characteristics to explain the phenomenon, but the inclusion of recessionary dummies into the model leads to controversial and puzzling results. A significant recessionary effect is found during the Nineties, accounting for inventories being more sensitive to financial frictions during the main recessionary peaks, 1993 and 1996. The result is not confirmed by the most recent estimates, especially the ones referring to the 2008–2009 recessionary shock, whose effects are investigated for the first time by a paper addressing the inventory investment–financial constraints subject. Alternative hypothesis for the proposed results have been tested on data. Firms were found to rely on inventory decumulation to a lesser extent compared to the past, to generate internal financing. More specifically, disinvestments in financial assets were found to represent, as a matter of fact, one of the main drivers adopted to ease liquidity tensions: a negative and strongly significant relationship with inventory investment was detected, after controlling for short-run liquidity constraints at firm level. By contrast, only a weak negative relationship was established with fixed capital during the same recessionary biennium.     

Holdup, search, and inefficiency

This paper investigates the holdup problem in the search market environment where players search for their trading partners and specific investments are made after matching but before trade decisions are taken. We show that markets with small frictions make the holdup problem more serious than those with large frictions because in any equilibrium, whether stationary or nonstationary, investment must reach the minimum level and trade must be delayed with positive probability for infinitely many time periods. We then show that the gap between equilibrium welfare and the first best welfare becomes larger as search frictions become smaller.     

Transition and the output fall

We present a model to explain why in the transition economies of Central andEastern Europe an important output fall has been associated with price liberalization. Its key ingredients are search frictions and Williamsonian relation-specific investment, implying that new investments are made only after having found a new long-term partner. When all firms search for new partners, output may fall because of three effects: a) disruption of previous production links, b) a fall in investment, and c) capital depreciation due to the absence of replacement investment. We show that forms of gradual liberalization like the Chinese 'dual-track' price liberalization may avoid the transitory output fall.
JEL classification: D21, D50, E30, E61, P41, P51.     

Labor market frictions and the international propagation mechanism

The paper studies the role of labor market frictions in accounting for international business cycle comovement. To this aim, we embed labor market search and matching frictions in a two-country New Keynesian model. We show that labor market frictions amplify the international propagation of supply and demand shocks. In terms of cyclical properties then, they raise the cross-country output correlation. Adding labor market search in the New Keynesian model thus improves its ability to account for the business cycle comovement observed in G7 countries in the recent decades. Nominal wage rigidity substantially contributes to this result. Labor market institutions also play a role. Yet, their impact is not unequivocal depending on the institution considered. Business cycle synchronization is thus found to increase with the generosity of the unemployment benefits system, whereas it decreases with the strictness of employment protection.     

News shocks and labour market dynamics in matching models

We enrich a baseline real business cycle (RBC) model with search and matching frictions on the labour market and real frictions that are helpful in accounting for the response of macroeconomic aggregates to shocks. The analysis allows shocks to have an unanticipated and a news (i.e., anticipated) component. The Bayesian estimation of the model reveals that the model that includes news shocks on macroeconomic aggregates produces a remarkable fit of the data. News shocks in stationary and non‐stationary TFP, investment‐specific productivity and preference shocks significantly affect labour market variables and explain a sizeable fraction of macroeconomic fluctuations at medium‐ and long‐run horizons. Historically, news shocks have played a relevant role for output, but they have had a limited influence on unemployment.     

Disentangling barriers to internationalization

Abstract. Recent literature on multinational firms has focused on low productivity as a barrier to the internationalization of firms. But labour market frictions or financial constraints may also hamper internationalization. In order to assess the importance of these barriers, we present new empirical evidence on the extensive and intensive margin of exports and foreign direct investment (FDI) based on micro‐level data of German firms. First, we find a positive impact of firm size and productivity on firms’ international activities. Second, labour market frictions can constitute barriers to foreign activities. Third, self‐reported financial constraints have no impact on firms’ internationalization decisions. JEL classification: F23, G2     

International business cycles and the relative price of investment goods

Abstract Is the relative price of investment goods a good proxy for investment specific technology? We model this relative price in a flexible price international economy with two fundamental shocks, namely, the total factor productivity (TFP) shock and the investment‐specific technology (IST) shock. We show that the one‐to‐one correspondence between the IST shock and the relative price of investment goods breaks down in an international economy because of the short‐run correlation between the terms of trade and the relative price of investment goods. The data congruent negative correlation between the investment rate and the relative price of investment goods thus does not necessarily reflect decline in investment frictions (rise in IST), as suggested by many studies. A calibration experiment with the US data demonstrates that such an inverse relation between rate of investment and the relative price of investment goods basically reflects the positive effect of TFP on the terms of trade for a broad range of economies where the home bias in consumption exceeds investment and there is a sizable adjustment cost of investment.     

Pervasive inattentiveness

In this paper we analyze how inattentiveness in capital investment decisions shapes business cycle dynamics in a dynamic stochastic general equilibrium (DSGE) model with inattentiveness. We find that the model with pervasive inattentiveness matches several business cycle moments much better than an otherwise identical model without informational frictions in investment. These findings reinforce the need for pervasive stickiness to mimic the inertia found in macroeconomic data.     

Inflation, investment and economic performance: The role of internal financing

This paper studies a link between inflation and economic activity that is built on two hypotheses. First, firms mitigate informational frictions in financial markets by accumulating retained earnings over a period of time. Second, firms allocate earnings among three competing uses - dividends, current investment, and the accumulation of internal funds - and inflation directly distorts this allocation decision as well as the real value of accumulated internal funds. The model predicts that the level of inflation - both unanticipated and expected inflation - as well as the variability of inflation distort firms’ internal financing decisions, increases frictions in financial markets, reduces the level and efficiency of investment, and reduces aggregate output. The marginal effects of inflation are increasing in the inflation rate.     

Economic Growth: The Case of Irreversibility of Investment with Bargaining Power of Workers

In this paper, we develop a model of endogenous growth with search frictions in the labor market. We show that the growth rate of the economy may be durably altered in a case of investment irreversibility and bargaining power of workers. Labor market conditions mitigate this rent-seeking effect of workers.     

Technology Shocks and Job Flows

We consider a version of the Solow growth model where technological progress can be investment specific or investment neutral. The labour market is subject to search frictions, and the existing productive units may fail to adopt the most recent technological advances. Technological progress can lead to the destruction of technologically obsolete jobs and cause unemployment. We calibrate the model to replicate the high persistence that characterizes the dynamics of firms' neutral technology and the frequency of firms' capital adjustment. We find that neutral technological advances increase job destruction and job reallocation and reduce aggregate employment. Investment-specific technological advances reduce job destruction, have mild effects on job creation, and are expansionary. Hence, neutral technological progress prompts Schumpeterian creative destruction, while investment-specific technological progress operates essentially as in the standard neoclassical growth model. Using structural VAR models, we provide support to the key dynamic implications of the model.     

FAMILY FIRMS,BANK RELATIONSHIPS,AND FINANCIAL CONSTRAINTS: A COMPREHENSIVE SCORE CARD

We examine the effect of financial constraints on firm investment and cash flow. We combine data from the Spanish Mercantile Registry and the Bank of Spain Credit Registry to classify firms according to whether they are family‐owned, not family‐owned, or belong to a family‐linked network of firms and according to their number of banking relations (with none, one, or several banks). Our empirical strategy is structural, based on a dynamic model solved numerically to generate the joint distribution of firm capital (size), investment, and cash flow, both in cross sections and in panel data. We consider three alternative financial settings: saving only, borrowing and lending, and moral hazard constrained state‐contingent credit. We estimate each setting via maximum likelihood and compare across these financial regimes. Based on the estimated financial regime, we show that family firms, especially those belonging to networks based on ownership, are associated with a more flexible market or contract environment and are less financially constrained than nonfamily firms. This result survives stratifications of family and nonfamily firms by bank status, region, industry, and time period. Family firms are better able to allocate funds and smooth investment across states of the world and over time, arguably done informally or using the cash flow generated at the level of the network. We also validate our structural approach by demonstrating that it performs well in traditional categories, by stratifying firms by size and age, and find that smaller and younger firms are more constrained than larger and older firms.     

Efficiency of two sided investments in an equilibrium unemployment framework

This paper investigates the efficiency of investments by firms and workers in a matching model with high- and low-productivity jobs. Search is sector specific and random within sectors. Search frictions and ex-post bargaining imply that wage inequality arises as a result of the difference in investment costs between the sectors. The efficiency properties of the equilibrium are analyzed under the particular division in bargaining proposed by Hosios (1990). The conclusion is that the equilibrium is inefficient, with a too low fraction of workers and a too high vacancy-unemployment ratio in the high-productivity sector. The opposite happens in the low-productivity sector.     

Aggregate fluctuations, financial constraints and risk sharing

Summary. Private information and costly state verification often result in credit rationing in models with smooth investment, affecting both loan size and total investment. The optimal contract is derived in a dynamic stochastic growth model with capital for two types of models: one with symmetric information and the other with asymmetric information and costly state verification. When all information is observed costlessly, the equilibrium optimal contract provides complete insurance to risk-averse savers against aggregate fluctuations. When information is asymmetric and there is costly state verification, the equilibrium optimal contract provides only partial insurance against aggregate shocks. The extent of insurance is measured by the marginal rate of transformation of consumption between borrowers and lenders which is closely linked to the user cost of capital. The deadweight monitoring costs create a wedge between a borrower's cost of capital and a lender's stochastic discount factor, with two results: (i) fluctuations in the user cost of capital provides a mechanism by which aggregate shocks can be␣propagated; (ii) the distribution of capital's share of output among borrowers, lenders, and monitoring costs varies even if capital's share is constant. Capital market frictions not only amplify aggregate fluctuations but also generate cross-sectional fluctuations that may not be observable in aggregate data. Received: November 17, 1997; revised version: April 20, 1998