Financial markets and economies around the world have experienced unprecedented turbulence in the past two years with output, consumption, trade and credit collapsing while default risk rising. This proposal contains three projects that study the aggregate implications of default risk on firm behavior, aggregate employment and world trade in environments that contain micro heterogeneity and default risk. The first project studies the impact of cross-country variation in financial market development on firms? financing choices and growth rates using comprehensive firm-level datasets from 27 European countries. The project documents that in less financially developed economies, small firms grow faster and have lower debt to asset ratios than large firms. The project then develops a model where financial frictions drive firm growth and debt financing. The PI's parameterize the model to the firms? financial structure in the data and show that financial restrictions can account for the majority of the difference in growth rates between firms across countries. The second project constructs a quantitative general equilibrium model of heterogenous firms that face default risk to analyze the impact of time varying uncertainty on aggregates. In the model, an increase in uncertainty leads firms to contract their size to avoid default. High uncertainty also has an amplification effect on firms output through tighter credit which contracts due to a rise in default risk. These effects are consistent with features of the financial crisis such as contractions in aggregates as well as high levels of uncertainty. The third project studies the interaction between global financial shocks and world trade. World trade experienced a 30% collapse during the recent financial crisis. This project develops a model of world trade and financial frictions to gain insights into the mechanisms by which a deterioration in financial conditions interact with countries? exports and imports.
Intellectual Merit: The proposal develops state of the art quantitative models with firm and aggregate shocks to analyze the interaction of firms? behavior in environments of financial imperfections. Using variation in micro data across firms (and countries) in models that contain micro heterogeneity allows a sharper evaluation of the empirical implications of models, both in the cross section and time series dimension. The proposal contains a general equilibrium model that studies the implications of high uncertainty and financial markets conditions. The methodological contribution consists of solving a model with micro and aggregate shocks in the presence of default risk. The proposal also employs multi-country firm level datasets and finds empirical evidence supporting a growing literature that argues that financial factors are the key drivers of firm growth.
Broader Impacts: The proposal provides a quantitative model designed to shed light on the recent financial crisis and to understand why firms reduce their employment in uncertain times. The model identifies which firms are most vulnerable during crisis and how resources can be allocated most efficiently to ameliorate the downturn. The model is also a useful tool to analyze which interventions in credit markets can be the most useful. The proposal also contains a new empirical finding regarding firm financing, growth and size across countries with varying financial markets and constructs a model that can rationalizes them. The quantitative model has important policy predictions for how financial institutions affects firms and how best to improve their conditions across countries.
