Ebook Volatility And Growth: Credit Constraints And Productivity-Enhancing Investment
The modern theory of business cycles gives a central position to productivity shocks and the role of financial markets in the propagation of these shocks; but it takes the entire productivity process as exogenous. The modern theory of growth, on the other hand, gives a central position to endogenous productivity growth and the role of financial markets in the growth process; but it focuses on trends, largely ignoring shocks and cycles.
The goal of this paper is to build a bridge between the two approaches; to propose and, in a limited way, test a theory of endogenous productivity growth that gives a central position to uncertainty. At the heart of our theory is a propagation mechanism how exogenous shocks generate endogenous productivity movements and its interaction with financial markets.
The first part of the paper develops a model that focuses on the cyclical behavior of the composition of investment as the main propagation channel; this choice is motivated by facts discussed later. Entrepreneurs engage in two types of investment activity: short-term investment takes relatively little time to build and generates output relatively fast; long-term investment takes more time to complete but contributes more to productivity growth.
With perfect credit markets, investment choices are dictated merely by an opportunity-cost effect. As long as short-term returns are more cyclical than long-term returns, the opportunity cost of long-term investment is lower in recessions than in booms. The fraction of savings allocated to long-term investment is therefore countercyclical and, by implication, the endogenous component of productivity grows faster when coming out of a recession than otherwise.
But with sufficiently imperfect credit markets, long-term investment becomes procyclical and the business cycle is now amplified. This is not so much because borrowing constraints limit the ability to invest; in our model the interest rate adjusts in general equilibrium so that neither type of investment is constrained ex ante. It is rather because tighter constraints imply a higher risk that long-term investment will be interrupted by some (idiosyncratic) liquidity shock ex post. This risk in turn reduces the entrepreneurs’ willingness to engage in long-term investment ex ante and the more so in recessions, when liquidity is expected to be scarce. Aggregate shocks therefore have a more pronounced effect on productivity growth when credit markets are less effective.
The second part of the paper confronts the implications of the model with the data. We first examine whether there is evidence of amplification per se. For that purpose, we look at a panel of about 60 countries over the 1960-1995 period and use export-weighted commodity price shocks as our measures of exogenous shocks to the economy. We find the negative growth impact of an adverse price shock, especially at two lags, to be stronger in countries with tighter credit.
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