Financial frictions on capital allocation: A transmission mechanism of TFP fluctuations

This paper provides a theory of financial frictions as a transmission mechanism for news shocks to drive aggregate TFP fluctuations. We show that in an economy calibrated to U.S. data, variations in financial frictions on capital allocation in response to news about future technology can generate aggregate TFP fluctuations and, thus, trigger business cycles before the actual technological change is realized. Using the COMPUSTAT dataset, we find that the relative capital productivity of financially constrained to unconstrained firms is highly countercyclical. Moreover, our VAR analysis shows that news shocks can account for a substantial fraction of the relative capital productivity fluctuations over business cycle frequencies. •We provide a theory of financial frictions as a transmission mechanism for primitive shocks to translate into aggregate TFP fluctuations.•Variations in financial frictions in response to news about future technology can generate aggregate TFP and business cycles fluctuations.•The relative capital productivity of financially constrained to unconstrained firms in the COMPUSTAT dataset is highly countercyclical.•News shocks account for a substantial fraction of the relative capital productivity fluctuations over business cycle frequencies.