DP1422 | Do Capital Market Imperfections Exacerbate Output Fluctuations?

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We develop a dynamic general equilibrium macroeconomic model where a proportion of firms are credit constrained due to asymmetric information. In general, a macroeconomic shock has additional effects created by a reallocation of funds between credit-constrained and unconstrained firms. We show that the output response to shocks is not necessarily amplified, however, and can be dampened by the presence of asymmetric information. This depends on the impact of the shock on the composition of external and internal funds for credit-constrained firms. Furthermore, we show that it is important to distinguish between firms? collateral and firms? cash flow in determining the dampening or amplifying effect of agency costs.