Fluctuations in Uncertainty, Efficient Borrowing Constraints and Firm Dynamics

In this paper, I quantify the importance of microeconomic uncertainty shocks for the firm dynamics over the business cycle in an economy with frictional financial markets. To begin, I document facts on asymmetric response across age and size groups of firms in the U.S. to the changes in aggregate economic conditions. I argue that age rather than size is a relevant margin for the magnitude of employment volatility over the cycle; in particular total employment of young firms varies 2.6 times more relative to the old firms. Then I propose a theory that, contrary to the existing studies, generates endogenously a link between firm's age and size and its ability to obtain financing, and induces an asymmetric response to shocks. A key element of my theory is a financial friction originating from the presence of the firm's private information and long-term, efficient lending contract between a risk averse entrepreneur and financial intermediary, which manifests itself as a borrowing constraint. I argue that, for any given expected return on project, young firms are more constrained in borrowing and they grow out of the constraint as they age up to the optimal, unconstrained size. Next I establish that, for any given age, firm's financing increases in line with the average return on a project. In times of high idiosyncratic uncertainty the financial contract calls for tightening of the borrowing constraint transmitting the initial impulse into a decline in demand for production inputs and further, including general equilibrium effects, into an economic downturn. This mechanism affects disproportionally young firms. Not only are they more constrained in borrowing but also they start smaller due to a reduced level of initial financing. A quantitative version of the model accounts for the fall of the aggregate output, employment and investment, decline of credit to GDP ratio and asymmetric employment dynamics of different groups of firms observed in the US data in recessions.