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Abstract: In the standard macro-finance model, financial constraints affect small or young firms but not large or old ones, and the implied dispersion in the marginal revenue product of capital (MRPK) of a firm cohort is less persistent compared to the data. We extend the model by allowing firm productivity to be endogenous to firms' financial constraints. With endogenous productivity, a firm's optimal demand for capital increases with collateral, financial constraints and dispersion of MRPK persist, and even large firms are likely to be constrained. Our model with endogenous productivity also amplifies productivity loss arising from financial frictions by two-fold.
Keywords: Collateral Constraint, Endogenous Firm Productivity, Firm Dynamics, Misallo- cation, Aggregate Productivity, China
JEL Classification: E13; G31; L16; L26; O41