Capital misallocation and productivity losses from financial frictions

First Chapter: Does capital misallocation from financial frictions cause substantial aggregate productivity losses? To explore this question, I propose a highly tractable theory featuring entrepreneurs who are subject to borrowing constraints and idiosyncratic productivity shocks. Productive entrepreneurs cannot raise capital in the market; however, they may self-finance investment in the sense of paying it out of their own savings. Such self-financing can undo capital misallocation if productivity shocks are sufficiently autocorrelated. If so, financial frictions have no effect on aggregate productivity. Conversely, productivity losses may be large if autocorrelation is low. My model economy is further isomorphic to an aggregate growth model with the difference that productivity is endogenous and depends on the quality of credit markets. This implies that financial frictions have no direct effect on aggregate output and savings; only an indirect one through aggregate productivity. In an application of the model, I estimate its critical parameters using plant-level panel data from two emerging market economies, show that it can match the allocation of capital within these economies, and calculate that financial frictions can explain aggregate productivity losses of up to twenty-five percent relative to the US.;Second Chapter: I study the implications of the limited enforceability of credit contracts for inequality and economic growth. I introduce limited enforcement into a deterministic neoclassical growth model. Two types of entrepreneurs differ in their initial wealth, ability and patience and each operate a private firm. The entrepreneurs can borrow and lend to each other but face enforcement constraints. This results in capital being misallocated across entrepreneurs. Three main conclusions are obtained from this model. First, capital misallocation disappears in the long run when entrepreneurs are equally patient. In contrast, when entrepreneurs' discount rates differ, capital misallocation persists asymptotically. Second, poor creditor rights magnify the effect of heterogeneity in ability on long run wealth inequality, because wealth accumulation functions as a substitute for poor creditor rights. Third, the interest rate is generally lower than in an economy without enforcement constraints, which has implications for the ability of the neoclassical growth model to explain sustained growth.