Fluctuations in Uncertainty, Efficient Borrowing Constraints and Firm Dynamics∗

This paper quantifies the importance of aggregate fluctuations in microeconomic uncertainty for firm dynamics over the business cycle in an economy with endogenously frictional financial markets. To begin, I provide evidence 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 cyclical employment dynamics; in particular total employment of young firms varies 2.6 times more relative to the old firms. Motivated by these observations, I propose a theory generating endogenously a link between firm’s age and size and its ability to obtain financing. A key element of my theory is a financial friction, originated from the firm’s private information and long-term, lending contract between firm and financial intermediary, which manifests itself as an efficient borrowing constraint. I show that, for any given size, young firms are more constrained in borrowing relative to the old ones. As the microeconomic uncertainty increases, the financial contract tightens the borrowing constraint to alleviate the cost of differentiating between good and poorly performing firms. This translates the initial impulse into a decline in demand of the constrained firms for production inputs, and further, including general equilibrium effects, into an economic downturn. Mechanism affects young firms disproportionally for two reasons: (i) majority of the constrained firms in the economy is young (ii) the size of new entrants is reduced due to lower initial financing available. A quantitative version of the model explains 50% of the fall in the aggregate employment and 72% of the differential response of employment between young and old firms observed in the US economy during the recent four recessions. In line with the data the economy experiences drop in output, investment and decline of credit to GDP ratio.