Abstract
We develop an endogenous growth model with heterogeneous firms, intermediate goods, and financial frictions, in which misallocation emerges analytically as a crucial state variable. In equilibrium, misallocation endogenously generates long-run uncertainty about economic growth by distorting innovation decisions, leading to significant welfare losses and risk premia in capital markets. Empirically, we construct a misallocation measure motivated by our model. We find evidence for misallocation-driven low-frequency movements in both aggregate growth and stock returns. A two-factor model with market and misallocation factors prices size, book-to-market, momentum, and bond portfolios with an R-squared and a mean absolute pricing error close to the Fama-French three-factor model.
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