Credit Market Frictions and the Linkage between Micro and Macro Uncertainty

Abstract

Micro uncertainty (cross-sectional dispersion) and macro uncertainty (volatility of aggregate economic variables) are conceptually distinct. However, empirically, they comove and are countercyclical. This paper builds a general equilibrium model and demonstrates that credit market frictions allow micro uncertainty to drive time-varying macro uncertainty endogenously. In the model, as dispersion increases, more firms are pushed to the left tail of the productivity distribution, resulting in more defaults and a depletion in aggregate net worth. This mechanism generates countercyclical leverage and aggregate volatility. The model implies that the government can inject equity in economic downturns to stabilize aggregate volatility.