Reassessing the Relevance of Financial Shocks in an Estimated Heterogeneous Firm Model

Abstract: I study the transmission of financial shocks using an estimated heterogeneous firm model. Following a contractionary financial shock, financially constrained firms cut investment, but unconstrained firms increase investment due to the lower capital price and interest rate. After matching the empirical dynamics of prices and the price elasticity of investment, I find a limited role of the unconstrained firms’ response in dampening the aggregate investment decline. Nonfinancial capital adjustment friction is the key to generating this result. Without the capital adjustment friction, unconstrained firms’ investment becomes unrealistically sensitive to prices, and the model would understate the financial shocks’ aggregate relevance.