Financial Intermediation and Capital Reallocation

To understand the link between financial intermediation activities and the real economy, we put forward a general equilibrium model where agency frictions in the financial sector affect the efficiency of capital reallocation across firms and generate aggregate economic fluctuations. We develop a recursive policy iteration approach to fully characterize the nonlinear equilibrium dynamics and the off-steady state crisis behavior. In our model, adverse shocks to agency frictions exacerbate capital misallocation and manifest themselves as variations in total factor productivity at the aggregate level. Our model endogenous generates counter-cyclical volatility in aggregate time series and counter-cyclical dispersion of marginal product of capital and asset returns in the cross-section.