Adverse selection, slow-moving capital, and misallocation

Abstract

We embed adverse selection into a dynamic, general equilibrium model with heterogeneous capital and study its implications for aggregate dynamics. The friction leads to delays in firms’ divestment decisions and thus slow recoveries from shocks, even when these shocks do not affect the economy’s potential output. The impediments to reallocation increase with the dispersion in productivity and decrease with the interest rate, the frequency of sectoral shocks, and households’ consumption smoothing motives. When households are risk averse, delaying reallocation serves as a hedge against future shocks, which can lead to persistent misallocation. Our model also provides a micro-foundation for convex adjustment costs and a link between the nature of these costs and the underlying economic environment.