Debt Financing, Used Capital Market and Capital Reallocation
I study how much financial frictions and the endogeneity of partially irreversible capital explain the slow recovery of the Great Recession. I propose a heterogeneous firm model with real and financial frictions. Firms adjust their capital stock by trading on the used capital market; thus, the capital partial irreversibility is endogenized by the price in the market. This irreversibility creates two opposite forces affecting investment volatility. First, capital investment is relatively cheaper in the recession, and thus attracts firms to invest in capital, dampening the fall of aggregate investment. Second, in a downturn, the capital becomes less reversible, and investments become riskier, exacerbating the fall of aggregate investment. In my model, the collateral constraint is procyclical since it is based on the resale value of the capital, and thus amplifies the first force and dampens the response of aggregate investment. I found that in the steady state, the used capital market induces firms to stay financially constrained due to lower effective capital prices. This status however may put these firms in a vulnerable position when the value of their collateral drops during a recession, as they heavily depend on debt to finance their capital investment. However, the perfect foresight exercise shows that the time-varying collateral constraint channel is relatively small. The main channel lies in the used capital market price, which acts as an automatic stabilizer during the credit crisis.
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