Working Paper Series no. 583: Credit frictions and the cleansing effect of recessions.

Abstract

Recessions are conventionally considered as times when the least productive firms are driven out of the market. How do credit frictions affect this cleansing effect of recessions? We build and calibrate a model of firm dynamics with credit frictions and endogenous entry and exit to investigate this question. We find that there is a cleansing effect of recessions in the presence of credit frictions, despite their effect on the selection of exiting and entering firms. This result holds true regardless of the nature of the recession: average firm-level productivity rises following a negative aggregate productivity shock, as well as following a negative financial shock. The intensity of the cleansing effect of recessions is however lower in the presence of credit frictions, especially when the recession is driven by a financial shock.

Sophie Osotimehin and Francesco Pappadà
March 2016

Classification JEL : E32, E44, D21.

Keywords : cleansing, business cycles, firm dynamics, credit frictions.