Heterogeneous producers facing common shocks: An overlapping-generations example

The extent to which market imperfections or institutional distortions amplify business cycle fluctuations is controversial. Competitive real-business-cycle models (for example, Kydland and Prescott 1982, Hansen 1985) imply that these factors play a secondary role. Other types of model imply that market imperfections can have a significant, adverse effect on welfare. In particular, Bernanke and Gertler (1989, 1995) analyze such a model of collateral constraints on lending to firms. One fact that Bernanke and Gertler (1995) adduce to argue that such constraints actually exist is that aggregate shocks affect small firms more dramatically than large firms in the U.S. economy. They remark that small firms do not have access to equity and commercial-paper markets, hypothesize that small firms are excluded from these markets because they have less collateral relative to their scale of operations than large firms have, and infer that the experience of actual small firms corroborates the implication of their model that collateral-constrained firms are particularly sensitive to shocks. This argument is only as strong as the hypothesis that a binding collateral constraint is the basis for exclusion from the market. An alternate hypothesis reverses the causality: small firms are unable to attract capital or to