Financing of Firms, Labor Reallocation, and the Distributional Role of Monetary Policy*

• Date: 01 April 2020
• Published date: 01 April 2020
• DOI: http://doi.org/10.1111/sjoe.12354

Scand. J. of Economics 122(2), 790–823, 2020

DOI: 10.1111/sjoe.12354

Financing of Firms, Labor Reallocation, and

the Distributional Role of Monetary Policy*

Salem Abo-Zaid

University of Maryland-Baltimore County,Baltimore, MD 21250, USA

salem.abozaid@umbc.edu

Anastasia Zervou

University of Texas at Austin, Austin, TX 78712, USA

zervoua@gmail.com

Abstract

We analyze monetary policy in a model with heterogeneous firms, where constrained firms

finance operations through external financing and unconstrained firms use internal funds. We

show that expansionary monetary policy increases the relative employment of constrained

firms, while positive productivity shocks increase that of unconstrained firms. Our results agree

with recent empirical findings, emphasizing the role of the monetary authority in reallocating

resources across sectors with different financing capabilities. We also show that if the relative

productivityof constrained firms is low, then expansionary monetary policy tilts resources towards

less productive firms, which decreases the effectiveness of the policy in stimulating aggregate

output.

Keywords: Firms’ financing; heterogeneous firms; labor reallocation; monetary policy

JEL classification:E32; E44; E52

I. Introduction

Firms are heterogeneous in terms of financing opportunities in that a large

share of them depend on borrowing to finance operations.1In addition,

empirical evidence shows that heterogeneous firms react differently to

economic shocks (Gertler and Gilchrist, 1994; Moscarini and Postel-Vinay,

2012; Chari et al., 2013; Fort etal., 2013; Kudlyak and Sanchez, 2017). With

this paper, we contribute to the existing body of literature by presenting

a simple model in order to study the implications of different financing

*Wethank Stephen Williamson, James Bullard, Charles Carlstrom, YiLiChien, Timothy Fuerst,

Francois Gourio, John Haltiwanger, FrancescoLippi, Vivien Lewis, Jonathan Meer, Christopher

Pissarides, Juan Sanchez, Jacek Suda, Christian Moser, Christian vom Lehn, RodrigoVelez, the

National Federation of Independent Business, and the participants at various conferences and

seminars.

1According to Rajan and Zingales (1998), more than 30 percent of the operation of US firms

depends on external finance.

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S. Abo-Zaid and A. Zervou 791

schemes for the cyclical sensitivity of heterogeneous firms following

economic shocks, as well as to examine the relative redistributive power of

these shocks. Our quantitative exercise reveals responses that are consistent

with those in the data, and stresses the redistributive role of monetary policy

in shifting resources across firms that differ in the way that they finance

their operation.

Specifically, we construct a limited participation model with two types

of firms: constrained firms that need to borrow in advance in order to

operate, and unconstrained firms that operate using internal resources.

As a result, the cost of external financing drives changes in relative

employment across the two sectors. We use this model to study the

effects of monetary policy and productivity shocks on labor. We find that

expansionary monetary policy benefits constrained firms, as it decreases

the cost of borrowing and leads to a rise in their labor and production.

Importantly, while expansionary monetary policy also leads to a rise in the

labor and production of unconstrained firms, the allocation of labor tilts in

favor of the constrained firms. In this respect, not only is monetary policy

effective in stimulating aggregate economic activity but it also plays a great

role in the distribution of economic activity across sectors. However, this

redistributive role might have undesirable consequences; if the constrained

firms are less productive than the unconstrained firms, then expansionary

monetary policy tilts resources towards the less productive firms, making

monetary policy less effective in stimulating aggregate activity. This result

emphasizes the limitation of representative-firm models in assessing the

effectiveness of monetary policy.

Apropos of productivity shocks, our model suggests that a positive

shock induces an increase in the production of financially constrained and

financially unconstrained firms. Yet, the surge in economic activity leads

to an increase in the interest rate and, thus, benefits the unconstrained

firms more than the constrained firms. The relative employment of the

unconstrained firms rises, making the unconstrained firms more cyclical

following productivity shocks. In the baseline model, where we assume the

same productivity across firms, the effects of productivity shocks on the

allocation of labor across sectors is considerably smaller than the effects of

monetary policy disturbances. When we allow for higher productivity for the

unconstrained firms or a muted rise in the productivity of the constrained

firms (which could reflect a slower adoption of new production technologies

by small firms), then the effects of productivity shocks on the relative

employment of constrained and unconstrained firms are greatly magnified.

Yet, the response of relative employment to productivity innovations remains

weaker than its response to monetary policy shocks.

In order to relate our findings to the empirical literature on differential

behavior of firms over the cycle and following shocks, we conjecture

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792 Financing of firms and distributional role of monetary policy

that small firms, in terms of assets or employment size, and young firms

are more likely to be constrained compared with large/old firms.2Then,

we assume that small/young firms rely on external financing, and thus

are subject to the external financing premium. This assumption has its

foundation in previous empirical work. For example, by studying the

investment of US manufacturing firms, Fazzari etal. (1988) find that smaller

firms are more likely to be liquidity constrained. Gertler and Hubard (1988)

find that smaller firms rely heavily on intermediary credit while large firms

use more direct credit. More recently, Shourideh and Ariel (2017) find

that private firms finance externally roughly 80 percent of their investment

contrary to only 20 percent for larger, publicly traded firms. Haltiwanger

et al. (2013) have highlighted the importance of the age of a firm for

understanding why firms react differently to shocks. Adelino et al. (2017)

show that, compared with older firms, young firms are more likely to face

severe financing constraints, and that job creation by new firms is larger in

areas with better access to small business financing.

The heterogeneous responses of firms to economic shocks have been

well documented in the empirical literature. Using the dates of monetary

policy shocks given by Romer and Romer (1989), Gertler and Gilchrist

(1994) conclude that small firms (i.e., firms with low values of gross

nominal assets) react more than larger firms; they severely reduce their sales

and inventories and, thus, are more cyclical than larger firms after monetary

policy shocks. Chari et al. (2013) and Kudlyak and Sanchez (2017) verify

these findings for a longer time period. Assuming that interest rate shocks

in our model map on to the dates of monetary shocks given by Romer and

Romer (1989), then the results that are generated by our model align with

the empirical evidence on the effects of monetary policy disturbances on

heterogeneous firms.

Regarding productivity shocks, Chari et al. (2013) find that after

recession dates given by the National Bureau of Economic Research

(NBER), large firms react more than small firms, thus reducing their sales

and inventories more. Kudlyak and Sanchez (2017) emphasize that this

effect holds also for the recent Great Recession. Moscarini and Postel-

Vinay (2012) find that large firms (in terms of employment) on net destroy

proportionally more jobs relative to small firms during a typical recession,

and that they create more jobs during a typical expansion. Our results

align with the above empirical findings if we consider positive (negative)

2While we do not explicitly model the size or age of firms, there are a few reasons behind our

assumption that small/young firms are more sensitive to the external financing premium. For

example, higher cash flows make it easier for larger firms to finance production internally. Also,

large/old firms that are traded can more easily raise capital internally.These effects are supported

by the discussion that follows concerning the empirical literature.

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