Bank lending and firm dynamics in general equilibrium

This paper investigates the impact of a change in aggregate credit supply on firm dynamics in an economy with financial frictions. We model a lifetime lending relationship between banks and firms in a general equilibrium framework with households making endogenous occupational decision. Financial markets are endogenously incomplete due to asymmetric information, and financial constraints emerge from the optimal financial contract. In equilibrium, we determine the interest rate and wage rate, as well as the share of entrepreneurs in the economy. Following the optimal contract, the distribution of firm size and firm dynamics such as size, growth, and volatility of growth are derived. Further, we introduce reserve requirements on banks, which induce tighter aggregate credit supply. The model shows that, as reserve ratio (i.e., the share of deposits as reserve) increases, the interest rate increases, the wage rate decreases, and the share of entrepreneur decreases in equilibrium. Aggregate capital supply and aggregate output decrease. In addition, not only do firms operate in smaller sizes on average, but also there is a reallocation of credit from young firms towards older ones, which implies a tighter financial constraint on the young firms in the economy.