Slow Recovery With Uncertainty Shocks and Optimal Firm Liquidation
AbstractI analyze optimal dynamic contracting between risk-averse investors and firm
insiders in a dynamic general equilibrium model with heterogeneous firms. Borrowing constraints arise endogenously in this economy because investors do not observe firm output. I quantify the effect of aggregate uncertainty shocks and show that with realistic parameters, such shocks can lead to recessions with a 4% drop in GDP. It takes 8 quarters for GDP to return to pre-crisis levels after uncertainty reverts back to lower levels. This slow recovery is due to a large increase in the severity of the agency problem faced by small and medium-sized firms. A significant fraction of these firms sharply reduce investment both during the recession and several quarters into the recovery phase. In contrast, a negative first moment shock to productivity generates a fast recovery from a similar drop in GDP.