Abstract

Abstract In China, state-owned firms exhibit easier access to external credit but have lower productivity than private firms. We construct a dynamic general equilibrium model incorporating heterogeneous financial frictions to investigate their impact on credit resource misallocation and macroeconomic fluctuations in the Chinese economy. A calibration of our model suggests that heterogeneity in financial frictions can reduce macroeconomic volatility. The mechanism is that heterogeneity in financial frictions induces the procyclicality of credit resource misallocation within entrepreneurs, thus the procyclicality of productivity loss. The stabilization effect depends on the relative magnitude of the impact of the shock on credit resource misallocation within entrepreneurs compared to its impact on the output. In addition, we show that the cost of the stabilization effect of heterogeneity in financial frictions is that it reduces the economy’s aggregate TFP and output at the steady state. Our results imply that neglecting heterogeneity may overestimate the impact of financial frictions on economic volatility in previous studies.

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