Financial Fragility, Patterns of Firms' Entry and Exit and Aggregate Dynamics

In this paper, extending the framework originally put forward by Greenwaldand Stiglitz (1988, 1990, 1993), we have developed a theoretical framework in which the financial conditions affect the capital accumulation decisions of the firm. In contrast to Greenwald and Stiglitz we allow for an unconstrained turnover of firms. In particular we will allow for an endogenously determined flow of exiting firms (through bankruptcy) and a stochastic flow of entrant firms.This entry-exit process will affect the dynamics of the distribution of firms which are differentiated by the equity ratio,i.e. the ratio of net worth to the capital stock. Aggregate variables (the capital stock, the equity base and aggregate output) can be interpreted as the outcome of a dynamic process which involves persistent financial heterogeneity and firms' turnover. It turns out that changes in financial conditions play an important role in determining output fluctuations. The ratio of financially fragile (Ponzi and speculative) firms to hedge units increases during the ascending phase of the business cycle as predicted in Minsky's financial instability hypothesis. We may also note that the entry and exit rates are strongly correlated, a prediction which is broadly consistent with the empirical evidence for advanced market economies