Productivity Losses From Financial Frictions

American Economic Review 2014, 104(10): 3186–3221
http://dx.doi.org/10.1257/aer.104.10.3186
Productivity Losses from Financial Frictions:

Can Self-Financing Undo Capital Misallocation?†
By Benjamin Moll*
I develop a highly tractable general equilibrium model in which

heterogeneous producers face collateral constraints, and study the
effect of financial frictions on capital misallocation and aggregate
productivity. My economy is isomorphic to a Solow model but with
time-varying TFP. I argue that the persistence of idiosyncratic pro-
ductivity shocks determines both the size of steady-state produc-
tivity losses and the speed of transitions: if shocks are persistent,
steady-state losses are small but transitions are slow. Even if finan-
cial frictions are unimportant in the long run, they tend to matter in
the short run and analyzing steady states only can be misleading.
(JEL E21, E22, E23, G32, L26, O16)
Underdeveloped countries often have underdeveloped financial markets. This can

lead to an inefficient allocation of capital, in turn translating into low productivity
and per capita income. But available theories of this mechanism often ignore the
effects of financial frictions on the accumulation of capital and wealth. Even if an
entrepreneur is not able to acquire capital in the market, he might just accumulate it
out of his own savings. This affects aggregates like gross domestic product (GDP),
both in long-run steady state and during transitions. Existing theories which take
into account accumulation are based on purely quantitative analyses, and almost
none of them consider transition dynamics.1 Relative to this literature, the objec-
tive of my paper is to develop a tractable dynamic general equilibrium model in
which heterogeneous producers face collateral constraints, and to use it to better
understand the effect of accumulation on both steady states and transition dynam-
ics. I emphasize transitions in addition to steady states because they are important in
their own right. They answer the basic question: if a developing country undertakes
* Department of Economics, Princeton University, 106 Fisher Hall, Princeton, NJ 08544 (e-mail: moll@
princeton.edu). I am extremely grateful to Rob Townsend, Fernando Alvarez, Paco Buera, Jean-Michel Lasry, Bob
Lucas, and Rob Shimer for many helpful comments and encouragement. I also thank Abhijit Banerjee, Silvia
Beltrametti, Roland Bénabou, Jess Benhabib, Nick Bloom, Lorenzo Caliendo, Wendy Carlin, Steve Davis, Steven
Durlauf, Jeremy Fox, Veronica Guerrieri, Lars-Peter Hansen, Chang-Tai Hsieh, Erik Hurst, Oleg Itskhoki, Joe
Kaboski, Anil Kashyap, Sam Kortum, David Lagakos, Guido Lorenzoni, Virgiliu Midrigan, Ezra Oberfield, Stavros
Panageas, Richard Rogerson, Chad Syverson, Nicholas Trachter, Harald Uhlig, Daniel Yi Xu, Luigi Zingales,
and seminar participants at the University of Chicago, Northwestern, UCLA, Berkeley, Princeton, Brown, LSE,
Columbia GSB, Stanford, Yale, the 2010 Research on Money and Markets conference, the 2009 SED and the
EEA-ESEM meetings, and three anonymous referees for very helpful comments. The author declares that he has no
relevant or material financial interests that relate to the research described in this paper.
†
Go to http://dx.doi.org/10.1257/aer.104.10.3186 to visit the article page for additional materials and author
disclosure statement(s).
1
A notable exception taking into account transitions is Buera and Shin (2013). See the related literature section
at the end of this introduction for a more detailed discussion.
3186
VOL. 104 NO. 10 Moll: Productivity Losses from Financial Frictions 3187
a reform, how long do its residents need to wait until they see tangible results and
what factors does this depend on? Related, transitions in models of financial fric-
tions have the potential to explain observed growth episodes such as the postwar
miracle economies.2
Consider an entrepreneur who begins with a business idea. In order to develop
his idea, he requires some capital and labor. The quality of his idea translates into his
productivity in using these resources. He hires workers in a competitive labor mar-
ket. Access to capital is more difficult, due to borrowing constraints; the entrepre-
neur is relatively poor and hence lacks the collateral required for taking out a loan.
Now consider a country with many such entrepreneurs: some poor, some rich; some
with great business ideas, others with ideas not worth implementing. In a country
with well-functioning credit markets, only the most productive entrepreneurs would
run businesses, while unproductive entrepreneurs would lend their money to the
more productive ones. In practice credit markets are imperfect so the equilibrium
allocation instead has the feature that the marginal product of capital in a good
entrepreneur’s operation exceeds the marginal product elsewhere. Reallocating cap-
ital to him from another entrepreneur with a low marginal product would increase
the country’s GDP. Failure to reallocate is therefore referred to as a misallocation
of capital. Such a misallocation of capital shows up in aggregate data as low total
factor productivity (TFP). Financial frictions thus have the potential to help explain
differences in per capita income.3
The argument just laid out has ignored the fact that entrepreneurs can potentially
overcome financial constraints through the accumulation of internal funds, and that
such self-financing therefore has the potential to undo capital misallocation.4 Over
time, not only an entrepreneur’s assets may change but also his productivity. It turns
out that this is key for the efficacy of self-financing.
My main result is that, depending on the persistence of productivity shocks, larger
steady-state productivity losses are associated with financial frictions being less
important during transitions. If productivity shocks are relatively transitory, financial
frictions result in large long-run productivity losses but a fast transition to steady state.
Conversely, sufficiently persistent shocks imply that steady-state productivity losses
are relatively small but that the transition to this steady state can take a long time. The
self-financing mechanism is key to understanding this result. Consider first the steady
state. If productivity shocks are sufficiently correlated over time, self-financing is
an effective substitute for credit access in the long run. Conversely, if shocks are
transitory, the ability of entrepreneurs to self-finance is hampered considerably. This
is intuitive. While self-financing is a valid substitute to a lack of external funds, it
takes time. Entrepreneurs will only have enough time to self-finance if productivity
2
This is in contrast to transitions in the neoclassical growth model which are characterized by very fast conver-
gence. See Buera and Shin (2013) who make this argument by means of a quantitative theory of endogenous TFP
dynamics in the presence of financial frictions.
3
I focus on the misallocation of capital rather than other resources because there is empirical evidence that this
is a particularly acute problem in developing countries (Banerjee and Duflo 2005; Banerjee and Moll 2010, and
the references cited therein). Restuccia and Rogerson (2008) and Hsieh and Klenow (2009) argue that resource
misallocation shows up as low TFP, and Klenow and Rodríguez-Clare (1997) and Hall and Jones (1999) argue that
cross-country income differences are primarily accounted for by TFP differences.
4
See Gentry and Hubbard (2004); Buera (2009); and Samphantharak and Townsend (2009) for evidence of
self-financing. Quadrini (2009) argues that this contributes to high wealth concentration among entrepreneurs.
3188 THE AMERICAN ECONOMIC REVIEW OCTOBER 2014
is s ufficiently persistent. The efficacy of self-financing then translates directly into

long-run productivity losses from financial frictions: they are large if shocks are tran-
sitory and small if they are persistent. Now consider the transition to steady state (say,
after a reform that improves financial markets or removes other distortions). That
transitions are slow when shocks are persistent and fast when they are transitory is the
exact flip side of the steady-state result: since self-financing takes time, it results in
the joint distribution of ability and wealth and therefore TFP evolving endogenously
over time, which in turn prolongs the transitions of the capital stock and output. In
contrast, transitory shocks imply that the transition dynamics of this joint distribution
are relatively short-lived and that TFP converges quickly to its steady-state value.
The primary contribution of this paper is to make this argument by means of
a tractable, dynamic theory of entrepreneurship and borrowing constraints. In the
model economy, aggregate GDP can be represented as an aggregate production
function. The key to this result is that individual production technologies feature
constant returns to scale in capital and labor. This assumption also implies that
knowledge of the share of wealth held by a given productivity type is sufficient for
assessing TFP losses from financial frictions. TFP turns out to be a simple, truncated
weighted average of productivities; the weights are given by the wealth shares and
the truncation is increasing in the quality of credit markets.5 The assumption of
individual constant returns furthermore delivers linear individual savings policies.
The economy then aggregates and is simply isomorphic to a Solow model with the
difference that TFP evolves endogenously over time. The evolution of TFP depends
only on the evolution of wealth shares. I finally assume that the stochastic process
for productivity is given by a mean-reverting diffusion. Wealth shares then obey a
simple differential equation which can be characterized tightly in steady state, and
solved numerically during transitions.6 Notably, this differential equation allows me
to prove that there exists a unique steady-state equilibrium and that TFP losses are
strictly decreasing in the persistence of shocks for a wide variety of ergodic stochas-
tic processes. The representation of the joint distribution of productivity and wealth
in terms of a differential equation for wealth shares and the characterization of its
properties are the main methodological contributions of my paper.
Related Literature.—A large theoretical literature studies the role of financial mar-
ket imperfections in economic development. Early contributions are by Banerjee and
Newman (1993); Galor and Zeira (1993); Aghion and Bolton (1997); and Piketty
(1997). See Banerjee and Duflo (2005) and Matsuyama (2007) for recent surveys.7
I contribute to this literature by developing a tractable theory of aggregate dynamics
with forward-looking savings at the individual level.
5
Lagos (2006) provides a similar microfoundation of TFP, but in terms of labor market frictions.
6
Solving for the transition dynamics in my model boils down to solving a single differential equation which is
a substantial improvement over commonly used techniques for computing transition dynamics in heterogeneous
agent models with financial frictions. A typical strategy uses Monte Carlo methods: one simulates a large number
of individual agents, traces the evolution of the distribution over time, and looks for an equilibrium, that is a fixed
point in prices such that factor markets clear (see for example Buera, Kaboski, and Shin 2011; Buera and Shin
2013). While solving for a stationary equilibrium in this fashion is relatively straightforward, solving for transition
dynamics is challenging. This is because an equilibrium is a fixed point of an entire sequence of prices (Buera and
Shin 2013).
7
There is an even larger empirical literature on this topic. A well-known example is by Rajan and Zingales
(1998). See Levine (2005) for a survey.
My paper is most closely related and complementary to a series of more recent,

quantitative papers relating financial frictions to aggregate productivity (Jeong and
Townsend 2007; Quintin 2008; Amaral and Quintin 2010; Buera, Kaboski, and Shin
2011; Buera and Shin 2013; Caselli and Gennaioli 2013; Midrigan and Xu 2014).
With the exception of Jeong and Townsend (2007) and Buera and Shin (2013), all
of these papers focus on steady states,8 and all of them feature purely quantitative
exercises. As a result, relatively little is known about transition dynamics and how
various aspects of the environment affect the papers’ quantitative results. In con-
trast, my paper offers a tractable theory of aggregate dynamics that I use to highlight
the role played by the persistence of productivity shocks in determining the size of
productivity losses from financial frictions, particularly the differential implications
of persistence for both steady states and transition dynamics. A finding with poten-
tially important implications for quantitative studies is that steady-state TFP is not
only increasing in persistence but also turns out to be a steep function of persistence
for high values of the latter, meaning that similar values of persistence may be quite
far apart from each other in terms of TFP losses.9
Caselli and Gennaioli (2013) provide one of the first frameworks linking financial
market imperfections to capital misallocation and cross-country TFP differences.
They are also the first to articulate the intuition that steady-state TFP losses are
decreasing in the persistence of productivity shocks.10 My paper differs from theirs
both in the framework used to make this point and the nature of the persistence
result. Caselli and Gennaioli study a dynastic economy in which individuals live
for one period and bequeath an exogenous fraction of their wealth to their offspring
(due to a warm glow motive). Productivity shocks take the form of talent draws at
birth and consequently their notion of persistence is the heritability of talent across
generations. In my framework, in contrast, entrepreneurs are infinitely lived and
adjust their assets in the face of new productivity shocks and not just once per gen-
eration.11 Given their interest in understanding the prevalence of dynastic manage-
ment in poor countries, Caselli and Gennaioli’s setup features a market for control in
which untalented heirs can potentially sell their firms to talented outsiders. In con-
trast, I abstract from such a market for simplicity. These differences in framework
8
My paper is complementary to Buera and Shin (2013), but differs along two dimensions. First, my model
is highly tractable, whereas their analysis is purely numerical, though in a somewhat more general framework
with decreasing returns and occupational choice. Second, they do not discuss the sensitivity of their results with
respect to the persistence of shocks. In a follow-up paper, Buera and Shin (2011) do examine the sensitivity of
steady-state productivity (and also welfare) losses to persistence, but not how it affects the speed of or productivity
losses during transitions. My paper also differs from Jeong and Townsend (2007) in various respects. Among other
differences, their model features overlapping generations of two-period-lived individuals. Hence individuals are
constrained to adjust their savings only once during their entire lifetime, which may be problematic for quantita-
tive results if the self-financing mechanism described earlier in this introduction is potent in reality. See Giné and
Townsend (2004); Jeong and Townsend (2008); and Townsend (2010) for more on transition dynamics. See Erosa
and Hidalgo-Cabrillana (2008) for another tractable model of finance and TFP with overlapping generations.
9
As I discuss in more detail in the paper, the steepness of TFP for high values of persistence potentially allows
for a reconciliation of some of the very different quantitative results in the literature (Buera, Kaboski, and Shin
2011; Midrigan and Xu 2014).
10
Related, Bénabou (2002, footnote 7) notes that in a model of human capital accumulation, the persistence
of ability or productivity shocks matters because it governs the intergenerational persistence of human wealth and
hence welfare. Gourio (2008) shows that also the effect of adjustment costs depends crucially on persistence. None
of these papers analyze the effect of persistence on transitions as in the present paper.
11
My entrepreneurs are also forward-looking and optimally split their profits between consumption and savings.
Among other things, this allows me to extend the model so as to examine the effect of variations in entrepreneurs’
risk aversion on steady-state TFP losses and capital-to-output ratios.
mean that the questions the two frameworks are most suited for also differ. Caselli
and Gennaioli’s setup is clearly more useful for understanding dynastic manage-
ment, but mine is for example more suited for studying transition dynamics follow-
ing reforms.12 Apart from these differences in framework, I add to their persistence
result in three respects. First, their steady-state result is numerical and for a par-
ticular stochastic process with two productivity types while I prove that TFP losses
are strictly decreasing in the persistence of shocks, and that this result holds for a
wide variety of stochastic processes with a continuum of productivity types. Second,
I add to this steady-state result by examining the effect of persistence on transition
dynamics and show that the case with small steady-state TFP losses is also the one
with slow transitions. Third, I analyze the effect of persistence on overall welfare in
the economy, thereby balancing its effect on steady states and transition dynamics.
Technologies in my framework are assumed to be concave, and I do not con-
sider the effect of nonconvexities in production (for example, fixed costs or other
indivisibilities) on the self-financing process. The idea that nonconvexities may
lead financial frictions to have large effects on the macroeconomy goes back to
Dasgupta and Ray (1986); Banerjee and Newman (1993); Galor and Zeira (1993);
and Ljungqvist (1993), and the same is true in the context of my paper.13 The reason
is that nonconvexities may disrupt the self-financing mechanism emphasized in my
paper: an entrepreneur who is too far below a particular nonconvexity would choose
not to save up even if high returns awaited at high asset levels.14 To the extent that
nonconvexities in production are important in reality, productivity losses from finan-
cial frictions in my framework should be viewed as a lower bound.
To deliver my model’s tractability, I build on work by Angeletos (2007) and
Kiyotaki and Moore (2012). Their insight is that heterogeneous agent economies
remain tractable if individual production functions feature constant returns to scale
because then individual policy rules are linear in individual wealth. In contrast to
the present paper, Angeletos focuses on the role of incomplete markets à la Bewley
and does not examine credit constraints (only the so-called natural borrowing limit).
Kiyotaki and Moore analyze a similar setup with borrowing constraints but focus
on aggregate fluctuations. Both papers assume that productivity shocks are i.i.d.
over time, an assumption I dispense with. Note that this is not a minor difference:
allowing for persistent shocks is on one hand considerably more challenging tech-
nically, but also changes results dramatically. Assuming i.i.d. shocks in my model
would lead one to miss most interesting transition dynamics. Persistent shocks are,
12
Caselli and Gennaioli’s framework is ill-suited to study transition dynamics because their assumption that
entrepreneurs adjust assets only once per generation implies that transitions will necessarily be slow.
13
See also Mookherjee and Ray (2003); Banerjee and Duflo (2005); and Banerjee and Moll (2010); Buera,
Kaboski, and Shin (2011); Midrigan and Xu (2014) for recent theoretical and quantitative analyses of this idea. A
concave technology is of course also the crucial assumption in the neoclassical growth model. Indeed, convergence
in the neoclassical growth model—in which the economy as a whole has no access to capital markets whatsoever—
can be viewed as stating that self-financing completely undoes all capital misallocation.
14
In the absence of random shocks, nonconvexities would result in poverty traps at the individual level. The same
may no longer be true when entrepreneurs face productivity shocks as in the present paper. However, nonconvexities
would still hamper entrepreneurs’ ability to self-finance considerably. Note the differential interaction of shocks
with the convex and nonconvex parts of the technology: shocks hamper self-financing when technology is convex,
but aid it when it is nonconvex.
of course, also the empirically relevant assumption.15 Buera and Moll (2012) use
the framework of the present paper, but to study business cycle fluctuations driven
by fluctuations in financial frictions rather than cross-country income differenc-
es.16 Finally, I contribute to broader work on the macroeconomic effects of micro-
distortions (Restuccia and Rogerson 2008; Hsieh and Klenow 2009; Bartelsman,
Haltiwanger, and Scarpetta 2013). Hsieh and Klenow (2009) in particular argue that
misallocation of both capital and labor substantially lowers aggregate TFP in India
and China. Their analysis makes use of abstract wedges between marginal products.
In contrast, I formally model one reason for such misallocation: financial frictions
resulting in a misallocation of capital.
After developing my model (Section I), I demonstrate the importance of the per-
sistence of productivity shocks (Section II), and discuss to what extent some of my
modeling choices can be relaxed (Section III). Section IV is a conclusion.
I. Model
A. Preferences and Technology
Time is continuous. There is a continuum of entrepreneurs that are indexed by

their productivity z and their wealth a. Productivity z follows some Markov process
(the exact process is irrelevant for now).17 I assume a law of large numbers so the
share of entrepreneurs experiencing any particular sequence of shocks is determin-
istic. At each point in time t, the state of the economy is then the joint distribution
gt(a, z). The corresponding marginal distributions are denoted by φ t(a) and ψ
t(z).
Entrepreneurs have preferences
피0 ∫    e−ρt

∞
(1) log c(t) dt.
0
Each entrepreneur owns a private firm which uses k units of capital and ℓ units of
labor to produce
(2) y = f (z, k, ℓ) = (zk)α ℓ1−α

units of output, where α ∈ (0, 1). Capital depreciates at the rate δ. There is also
a mass L of workers. Each worker is endowed with one efficiency unit of labor
which he supplies inelastically. Workers have the same preferences as (1) with the
15
Kiyotaki (1998) does allow for persistent shocks but in a considerably less general way than in my paper
(a two-state Markov chain). Other papers exploiting linear savings policy rules in environments with heterogeneous
agents are Banerjee and Newman (2003); Azariadis and Kaas (2012); Kocherlakota (2009); and Krebs (2003).
Bénabou (2002) shows that even with nonconstant returns, it is possible to retain tractability in heterogeneous agent
economies by combining log linear individual technologies with log normally distributed shocks, thereby allowing
him to study issues of redistribution. In my model with constant returns to scale, there is no motive for progressive
redistribution (except possibly the provision of insurance).
16
In particular, they study in more detail one implication of my framework, namely that financial frictions have
no direct effect on aggregate savings and instead affect savings indirectly through TFP, and relate this to the litera-
ture using wedges to summarize business cycles.
17
Here, productivity is a stand-in term for a variety of factors such as entrepreneurial ability, an idea for a new
product, an investment opportunity, but also demand-side factors such as idiosyncratic demand shocks.
e xception that they face no uncertainty so the expectation is redundant. The assump-
tion of logarithmic utility makes analytical characterization easier but can be gener-
alized to constant relative risk aversion (CRRA) utility at the expense of some extra
notation. See Section III that discusses this extension.
B. Budgets
Entrepreneurs hire workers in a competitive labor market at a wage w(t). They

also rent capital from other entrepreneurs in a competitive capital rental market at a
rental rate R(t). This rental rate equals the user cost of capital: that is R(t) = r(t) + δ,
where r(t) is the interest rate and δ the depreciation rate. An entrepreneurs’ wealth,
denoted by a(t), then evolves according to
(3)  ˙a = f (z, k, ℓ) − wℓ − (r + δ)k + ra − c.
˙ equal profits—output minus payments to labor and capital—plus interest

Savings  a
income minus consumption. The setup with a rental market is chosen solely for sim-
plicity. I show in Appendix C that it is equivalent to a setup in which entrepreneurs
own and accumulate capital k and can trade in a risk-free bond.
Entrepreneurs face collateral constraints
(4) k ≤ λa, λ ≥ 1.
This formulation of capital market imperfections is analytically convenient.

Moreover, by placing a restriction on an entrepreneur’s leverage ratio k/a, it cap-
tures the common intuition that the amount of capital available to an entrepreneur
is limited by his personal assets. Different underlying frictions can give rise to such
collateral constraints.18 Finally, note that by varying λ, I can trace out all degrees
of efficiency of capital markets; λ = ∞ corresponds to a perfect capital market,
and λ = 1 to the case where it is completely shut down. λ therefore captures the
degree of financial development, and one can give it an institutional interpretation.
The form of the constraint (4) is more restrictive than required to derive my results,
a point I discuss in more detail in online Appendix D. I show there that all my
theoretical results go through with slight modification for the case where the maxi-
mum leverage ratio λ is an arbitrary function of productivity so that (4) becomes
k ≤ λ(z) a. The maximum leverage ratio may also depend on the interest rate and
wages, calendar time, and other aggregate variables. What is crucial is that the col-
lateral constraint is linear in wealth. Entrepreneurs are allowed to hold negative
wealth, but I show below that they never find it optimal to do so.
18
For example, the constraint can be motivated as arising from a limited enforcement problem. Consider an
entrepreneur with wealth a who rents k units of capital. The entrepreneur can steal a fraction 1/λ of rented capital.
As a punishment, he would lose his wealth. In equilibrium, the financial intermediary will rent capital up to the
point where individuals would have an incentive to steal the rented capital, implying a collateral constraint k/λ ≤ a
or k ≤ λa. See Banerjee and Newman (2003) and Buera and Shin (2013) for a similar motivation of the same form
of constraint. Note, however, that the constraint is essentially static because it rules out optimal long term contracts
(as in Kehoe and Levine 2001, for example). On the other hand, as Banerjee and Newman put it: “there is no reason
to believe that more complex contracts will eliminate the imperfection altogether, nor diminish the importance of
current wealth in limiting investment.”
I assume that workers cannot save so that they are in effect hand-to-mouth work-
ers who immediately consume their earnings. Workers can therefore be omitted
from the remainder of the analysis.19
C. Individual Behavior
Entrepreneurs maximize the present discounted value of utility from consump-

tion (1) subject to their budget constraints (3). Their production and savings/
consumption decisions separate in a convenient way. Define the profit function
(5) Π(a, z) = max { f (z, k, ℓ) − wℓ − (r + δ)k s.t. k ≤ λa }.

k,ℓ
Note that profits depend on wealth a due to the presence of the collateral con-
straints (4). The budget constraint (3) can now be rewritten as
 ˙a = Π(a, z) + ra − c.
The interpretation is that entrepreneurs solve a static profit maximization problem

period by period. They then decide to split those profits (plus interest income ra)
between consumption and savings.
Lemma 1: Factor demands and profits are linear in wealth, and there is a produc-
tivity cutoff for being active _z :
k(a, z) =
{ λa,
0,
z ≥ _z
z < _z
ℓ(a, z) = _ (
1 − α 1/α
)
  w   z k(a, z)
Π(a, z) = max{zπ − r − δ, 0} λa, π = α _ (

1 − α (1−α)/α
  w   )
.
The productivity cutoff is defined by _zπ = r + δ.
(All proofs are in the Appendix.) Both the linearity and cutoff properties follow
directly from the fact that individual technologies (2) display constant returns to
19
A more natural assumption can be made when one is only interested in the economy’s long-run equilibrium.
Allow workers to save so that their wealth evolves as  a ˙ = w + ra − c, but impose that they cannot hold negative
wealth, a(t) ≥ 0 for all t. Workers then face a standard deterministic savings problem so that they decumulate
wealth whenever the interest rate is smaller than the rate of time preference, r < ρ. It turns out that the steady-state
equilibrium interest rate always satisfies this inequality (see Corollary 1). Together with the constraint that a(t) ≥ 0,
this immediately implies that workers hold zero wealth in the long run. Therefore, even if I allowed workers to save,
in the long run they would endogenously choose to be hand-to-mouth workers. Alternatively, one can extend the
model to the case where workers face labor income risk and therefore save in equilibrium even if r < ρ. Numerical
results for both cases are available upon request.
scale in capital and labor. Maximizing out over labor in (5), profits are linear in
capital, k. It follows that the optimal capital choice is at a corner: it is zero for
entrepreneurs with low productivity, and the maximal amount allowed by the col-
lateral constraints, λa, for those with high productivity. The productivity of the mar-
ginal entrepreneur is _z . For him, the return on one unit of capital zπ equals the cost of
acquiring that unit r + δ. The linearity of profits and factor demands delivers much
of the tractability of my model. In particular it implies a law of motion for wealth
that is linear in wealth
 ˙a = [ λ max {zπ − r − δ, 0} + r ]a − c.
This linearity allows me to derive a closed-form solution for the optimal savings
policy function.
Lemma 2: The optimal savings policy function is linear in wealth
(6)  ˙a = s(z)a, where s(z) = λ max {zπ − r − δ, 0} + r − ρ
is the savings rate of productivity type z.
Importantly, savings are characterized by a constant savings rate out of wealth. This
is a direct consequence of the assumption of log utility combined with the linearity
of profits. Note also that the linear savings policy implies that entrepreneurs never
find it optimal to let their wealth go negative, a(t) ≥ 0 for all t, even though this was
not imposed.
D. Equilibrium and Aggregate Dynamics
An equilibrium in this economy is defined in the usual way. That is, an equilib-
rium is time paths for prices r(t), w(t), t ≥ 0 and corresponding quantities, such that
(i) entrepreneurs maximize (1) subject to (3) taking as given equilibrium prices, and
(ii) the capital and labor markets clear at each point in time
(7) ∫  kt(a, z) dGt(a, z) = ∫  a dGt(a, z),

(8) ∫  ℓt(a, z) dGt(a, z) = L.

The goal of this subsection is to characterize such an equilibrium. The following

object will be convenient for this task and throughout the remainder of the paper.
Define the share of wealth held by productivity type z by
ω(z, t) ≡  _  ∫    agt(a, z) da,

∞
1
(9)
K(t) 0
where K(t) ≡ ∫   a dGt(a, z) is the aggregate capital stock. See Kiyotaki (1998) and
Caselli and Gennaioli (2013) for other papers using wealth shares to characterize
aggregates. As will become clear momentarily ω(z, t) plays the role of a density.
It is therefore also useful to define the analogue of the corresponding cumulative
distribution function
∫    ω(x, t) dx.

z
Ω(z, t) ≡
0
Consider the capital market-clearing condition (7). Using that k = λa, for all
active entrepreneurs (z ≥ _z ), it becomes
λ(1 − Ω( _z, t)) = 1.
Given wealth shares, this equation immediately pins down the threshold _zas a func-
tion of the quality of credit markets λ. Similarly, we can derive the law of motion
for aggregate capital by integrating (6) over all entrepreneurs. Using the definition
of the wealth shares (9), we get
˙ (t) = ∫    s(z, t) ω(z, t) dzK(t)

∞
(10)  K
0
∫    [ λ max {zπ(t) − r(t) − δ, 0} + r(t) − ρ ]ω(z, t) dzK(t).

∞
=

0
Using similar manipulations, we obtain our first main result.
Proposition 1: Given a time path for wealth shares ω(z, t), t ≥ 0, aggregate
quantities satisfy
(11) Y = ZKα L1−α

,
(12) ˙ = αZKαL1−α
 K − (ρ + δ)K,
where K and L are aggregate capital and labor and
(
∫    zω(z, t) dz
)
∞ α
(13) Z(t) = __       = 피ω,

t [ z | z ≥
_z ]
α
_z
   
1 − Ω( _z, t)
is measured TFP. The productivity cutoff z_is defined by
(14) λ(1 − Ω( _z , t)) = 1.
Factor prices are
(15) w = (1 − α)ZKαL−α
and r = α ζ ZKα−1 − δ,
L1−α
z_
where ζ ≡  __
    ∈ [ 0, 1].
피ω,
t [ z | z ≥
_z ]
The interpretation of this result is straightforward. In terms of aggregate

GDP, this economy is isomorphic to one with an aggregate production function,
Y = ZKα L1−α
. The sole difference is that TFP Z(t) is endogenous and as in (13). TFP
is simply a weighted average of the productivities of active entrepreneurs (those with
productivity z ≥ _z ). As already discussed, (14) is the capital market clearing condi-
tion. Because Ω( · , t) is increasing, it can be seen that the productivity threshold for
being an active entrepreneur is strictly increasing in the quality of credit markets
λ. This implies that, as credit markets improve, the number of active entrepreneurs
decreases, and their average productivity increases. Because truncated expectations
such as (13) are increasing in the point of truncation, it follows that TFP is always
increasing in λ (for given wealth shares).
Condition (12) gives a simple law of motion for the aggregate savings. The key to
this aggregation result is that individual savings policy rules are linear as shown in
Lemma 1. This law of motion can be written as
˙ ≡   s Y −   δ K,

 K where   s   ≡ α and  δ  ≡ ρ + δ
are constant savings and depreciation rates. This is the same law of motion as in the
classic paper by Solow (1956). What is surprising about this observation is that the
starting point of this paper—heterogeneous entrepreneurs who are subject to bor-
rowing constraints—is very far from an aggregate growth model such as Solow’s.20
One twist differentiates the model from an aggregate growth model: TFP Z(t) is
endogenous. It is determined by the quality of credit markets and the evolution of
the distribution of wealth as summarized by the wealth shares ω(z, t). I show in
Section IF below that, given a stochastic process for idiosyncratic productivity z,
one can construct a time path for the wealth shares ω(z, t). In turn, a time path for
TFP Z(t) is implied. But given this evolution of TFP—says Proposition 1—aggre-
gate capital and output behave as in an aggregate growth model. One immediate
implication of interest is that financial frictions as measured by the parameter λ have
no direct effects on aggregate savings; they only affect savings indirectly through
TFP. This result is discussed in more detail by Buera and Moll (2012) in the context
of business cycle fluctuations driven by fluctuations in financial frictions, provid-
ing a detailed intuition. The result is exact only for logarithmic utility, but I show
in Section III by means of numerical simulations that it holds approximately with
CRRA preferences under standard parameter values.21
The wage rate in (15) simply equals the aggregate marginal product of labor. This is
to be expected since labor markets are frictionless and hence individual marginal prod-
ucts are equalized among each other and also equal the aggregate marginal product.
The same is not true for the rental rate R. It equals the aggregate marginal product of
20
The reader may also wonder why the model aggregates to a Solow model even though the environment has
optimizing households à la Ramsey. This is the consequence of three assumptions: (i) the separation of individuals
into entrepreneurs and workers, (ii) that workers cannot save, and (iii) log utility for the entrepreneurs. More detail
is provided in the online Appendix at http: //www.princeton.edu/~moll/capitalists-workers.pdf where I explore this
result in the most stripped-down version of the model that delivers this result: an almost standard neoclassical
growth model (with no heterogeneity as here).
21
That is, as long as the intertemporal elasticity of substitution is not too far away from one. Also see Buera and
Moll (2012) who further show that the result is robust to departures from the assumption that workers cannot save
in the present paper.
capital αZKα−1 L1−α

scaled by a constant ζ that is generally smaller than 1. Intuitively,
the rental rate equals the marginal product of capital of the marginal productivity type
_z rather than the aggregate marginal product of capital—i.e., the marginal product of
type 피ω, t[ z | z ≥ _z ] and in general the former is smaller than the latter as reflected in
ζ < 1. The two are only equal in the first-best λ = ∞ so that only the most productive
entrepreneur is active, _z = max { z } (of course, the support of z must also be finite so
that max { z } exists). In all other cases, ζ < 1 so that the rental rate is lower than the
aggregate marginal product of capital. In the extreme case where capital markets are
completely shut down, λ = 1, the rental rate equals the return on capital of the least
productive entrepreneur (typically zero). The rental rate R = r + δ is also the return
on capital faced by a hypothetical investor outside the economy. The observation that
rental rates are low therefore also speaks to the classic question of Lucas (1990):
“Why doesn’t capital flow from rich to poor countries?” It may be precisely capital
market imperfections within poor countries which bring down the return on capital,
thereby limiting capital flows from rich countries. That financial frictions break the
link between the interest rate and the aggregate marginal product of capital also has
some implications for the dynamic behavior of the interest rate r(t). I will highlight
one of those when discussing transition dynamics in Section IV, namely that—in
contrast to transition dynamics in the neoclassical growth model—it is possible for
both the interest rate and the capital stock to be growing at the same time.
E. Steady-State Equilibrium
A steady-state equilibrium is a competitive equilibrium satisfying
˙ (t) = 0,
(16)  K ω(z, t) = ω(z), r(t) = r, w(t) = w for all t.
Imposing these restrictions in Proposition 1 yields the following immediate corollary.
Corollary 1: Given stationary wealth shares ω(z), aggregate steady-state

quantities solve
(17) Y = ZKα L1−α

(18) αZKα−1 = ρ + δ,
L1−α
where K and L are aggregate capital and labor and
(∫    zω(z) dz
)
∞ α
_
Z =     
z_
   =
E ω[ z | z ≥ _z ]α
1 − Ω(_z )
is measured TFP. The productivity cutoff _zis defined by λ(1 − Ω(_z)) = 1. Factor
prices are w = (1 − α)ZKα L−α and r = αζZKα−1
L1−α− δ = ζ( ρ + δ) − δ, where
ζ ≡ _z /E ω [ z | z ≥ _z ] ∈ [ 0, 1 ].
Most expressions have exactly the same interpretation as in the dynamic equilibrium
above. (18) says that the aggregate steady-state capital stock in the economy solves
a condition that is precisely the same as in a standard neoclassical, namely that the
aggregate marginal product of capital equals the sum of the rate of time preference
and the depreciation rate.
Condition (18) further implies that the capital-output ratio in this economy is
given by
α
 _  =  _ ,
K
(19)
Y ρ + δ
which is again the same expression as in a standard neoclassical growth model. The
capital-output ratio does not depend on the quality of credit markets, λ. This is con-
sistent with the finding in the development accounting literature that capital-output
ratios explain only a relatively modest fraction of cross-country income differences
(Hall and Jones 1999).22
F. The Evolution of Wealth Shares
The description of equilibrium so far has taken as given the evolution of wealth
shares ω(z, t). The statements in Proposition 1 and Corollary 1 were of the form:
given a time path for ω(z, t), t ≥ 0, statement [...] is true. This section fills in for the
missing piece and explains how to characterize the evolution of wealth shares.
Note first that the evolution of wealth shares ω(z, t) and hence TFP losses from
financial frictions depend crucially on the assumptions placed on the stochastic
process for idiosyncratic productivity z. Consider the extreme example where each
entrepreneur’s productivity is fixed z(t) = z for all t. In this case, financial frictions
will have no effect on aggregate TFP asymptotically. To see this, consider the opti-
mal savings policy function, a  ˙ (t) = s(z) a(t) (see Lemma 2), and note that the sav-
ings rate s(z) is increasing in productivity z. Since productivity is fixed over time,
the entrepreneurs with the highest productivity max{ z } will always accumulate at a
faster pace than others. In the long run (as t → ∞), the most productive entrepreneur
will therefore hold all the wealth in the economy, implying that his stationary wealth
share is 1,
  lim ω(z, t) =
t→∞ { 1,
0,
z = max{ z }
z < max{ z }.
It follows immediately that TFP Z(t) → max{z}αas t → ∞. Steady-state TFP and

GDP are first-best regardless of the quality of credit markets, λ. The interpretation
22
Hall and Jones (1999) do present evidence that capital-output ratios are higher in notably richer countries so
my result that they do not vary across countries is a bit extreme. However, as argued by Hsieh and Klenow (2007),
low investment rates in poor are due to low efficiency in producing investment goods rather than low savings
rates. Therefore investment rates—which in my model equal I/Y = δK/Y = δα/(ρ + δ)—differ much less across
countries when evaluated at domestic rather than PPP prices. The same is true for capital-output ratios (Caselli and
Feyrer 2007).
of this result is that, asymptotically, self-financing completely undoes all capital

misallocation caused by financial frictions.23
If productivity z follows a nondegenerate stochastic process, this is—in general—
no longer true. On the opposite extreme of fixed productivities, consider the case
where productivity shocks are assumed to be i.i.d. over time as in Angeletos (2007)
and Kiyotaki and Moore (2012).24 In this case, wealth and productivity will be inde-
pendent gt(a, z) = φt(a) ψ(z) because i.i.d. shocks imply that productivity shocks are
unpredictable at the time when savings decisions are made. It follows directly from
the definition of the wealth shares in (9) that ω(z, t) = ψ(z) for all t. In this case, pro-
ductivity losses will be large. The reason is that with i.i.d. shocks, productive firms
today were likely unproductive yesterday so that they are poor and financially con-
strained; put differently, i.i.d. shocks assume away any possibility for entrepreneurs
to self-finance their investments.25 However, as I will argue in Sections II and III,
the assumption of i.i.d. shocks is empirically irrelevant and would lead one to draw
false conclusions for the steady state and transition dynamics of the model.
In the intermediate range between the two extremes of fixed and i.i.d. productiv-
ity, things are more interesting. However, characterizing the evolution of wealth
shares is also harder. To make some headway for this case, I assume that productiv-
ity, z, follows a diffusion which is simply the continuous time version of a Markov
process:26
(20) dz = μ(z)dt + σ(z)dW.
μ(z) is called the drift term and σ(z) the diffusion term. In addition, I assume that
this diffusion is ergodic so that it allows for a unique stationary distribution. I would
like to note here that other stochastic processes are also possible. For example, a
version in which z follows a Poisson process is available upon request.
The following proposition is the main tool for characterizing the evolution of
wealth shares ω(z, t).
Proposition 2: The wealth shares ω(z, t) obey the second-order partial differ-
ential equation
[ ]
∂ ω(z, t) ˙ (t)
(21) _
  ∂ t = s(z, t) −  _ ω(z, −  _∂
[ μ(z) ω(z, +  _1  _
∂ 2
[ σ 2(z) ω(z, t)].
 K
K(t)
t) ∂ z
t)] 2 ∂ z 2
23
See Banerjee and Moll (2010) for a very similar result. Of course, the distribution of wealth and welfare will
be different than those in the first-best allocation.
24
A continuous time setup is of course not very amenable to i.i.d. shocks. See the simpler discrete time setup
with i.i.d. shocks in the online Appendix.
25
Note that this result also relies on the fact that my model features linear consumption and saving functions
(Lemma 2) and hence no precautionary savings. This follows because utility functions are of the CRRA form and
all risk is rate-of-return risk (Carroll and Kimball 1996). Departing from these assumptions, consumption functions
would be strictly concave and hence precautionary savings would allow for partial self-financing.
26
Readers who are unfamiliar with stochastic processes in continuous time may want to read the simple discrete
time setup with i.i.d. shocks in the online Appendix. The present setup in continuous time allows me to derive more
general results, particularly with regard to the persistence of shocks which is the central theme in this paper.
he wealth shares must also be nonnegative, bounded, continuous, and once dif-
T
∞
ferentiable everywhere, integrate to one for all t ∫   0  ω(z, t) dz = 1, and satisfy the
initial condition ω(0, t) = ω0(z) for all z.
The stationary wealth shares ω(z) obey the second-order ordinary differential
equation
1 d 2 2
0 = s(z) ω(z) −  _  [ μ(z) ω(z)] +  _  _
    [ σ (z)ω(z)].
d
(22)
dz 2 dz 2
he stationary wealth shares must also be nonnegative, bounded, continuous, and

T
∞
once differentiable everywhere, and integrate to one, ∫   0  ω(z) dz = 1.27
This partial differential equation (PDE) and the related ordinary differential equa-
tion (ODE) are mathematically similar to the Kolmogorov forward equation used to
keep track of cross-sectional distributions of diffusion processes.28 Solving for the
wealth shares also requires solving for equilibrium prices and aggregate quantities
which satisfy the equilibrium conditions (11) to (15). See online Appendix J for a
general algorithm for computing equilibria.
More can be said about stationary equilibria. In particular, one can prove exis-
tence and uniqueness under one additional assumption.
Assumption 1: The productivity process (20) is either naturally bounded or it is

_
reflected at zero and some arbitrarily large but finite upper bound z .
Under this relatively mild technical assumption, it is sufficient to examine the behav-
_
ior of the wealth shares ω(z) on a bounded interval [ 0, z  ] rather than the entire posi-
tive real line.
Proposition 3: For any ergodic productivity process (20) satisfying

Assumption 1, there exists a unique stationary equilibrium, that is, a solution to
(22) with appropriate boundary conditions, s(z) defined in Lemma 2, and r and w
defined in Corollary 1.
The rough idea of the proof is to view (22) as a continuous eigenvalue problem with
a steady state corresponding to a zero eigenvalue, and to show that (given capital
market clearing) this eigenvalue is monotone in the wage rate w and therefore inter-
sects zero exactly once.29
27
I here leave open the question of precise boundary conditions. These have to be determined on a case by case
basis, depending on the particular process (20) one wishes to analyze. Below I provide a numerical example with a
reflecting barrier providing a boundary condition, and two analytic examples in which one boundary condition can
be replaced because the solution has two branches one of which can be set to zero because it explodes as z tends
to infinity.
28
There is unfortunately no straightforward intuition for these equations so that readers who are unfamiliar with
the related mathematics will have to take them at face value. For readers who are familiar with it: If the function
˙ (t)/K(t) were identically zero, these equations would coincide with the forward equation for the marginal
s(z, t) −  K
˙ (t)/K(t) functions like a Poisson killing rate (however note
distribution of productivities ψ(z, t). The term s(z, t) −  K
that it generally takes both positive and negative values).
29
I thank Jean-Michel Lasry for teaching me how to analyze continuous eigenvalue problems.
One feature of the model’s steady-state equilibria deserves further treatment. The
stationary wealth shares in Corollary 1 and Proposition 2 are defined by
ω(z) ≡  _  ∫    agt(a, z) da.

1 ∞
(23)
K 0
Note that the joint distribution of productivity and wealth g t(a, z) carries a t sub-
script. The reason is that, while aggregates are constant in a steady-state equilib-
rium, there is no steady state for the joint distribution of productivity and wealth
gt(a, z). The same phenomenon occurs in the papers by Krebs (2003) and Angeletos
(2007). To understand this, note that the growth rate of wealth (that is the savings
rate s(z)) depends on (stochastic) productivity z but not on wealth itself. Wealth
therefore follows a random growth process. This implies that the wealth distribution
always fans out over time and does not admit a stationary distribution. If the model
were set up in discrete time, the log of wealth would follow a random walk which
is the prototypical example of a process without a stationary distribution. However,
and despite the fact that the joint distribution gt(a, z) is nonstationary, the wealth
shares ω(z, t) still admit a stationary measure ω(z) defined as in (23). This allows me
to completely sidestep the nonexistence of a stationary wealth distribution.
It is relatively easy to extend the model in a way that allows for a stationary
wealth distribution. In a brief note (Moll 2012), I show how this can be achieved
by introducing death shocks.30 At a Poisson rate ε > 0 some entrepreneurs who are
randomly selected from the entire population get replaced with new entrepreneurs
who begin life with some finite wealth level. This introduces mean-reversion and
ensures that a stationary distribution exists, even for arbitrarily small ε. An exten-
sion with a stationary wealth distribution features a stationary firm-size distribu-
tion (from Lemma 1, employment of active entrepreneurs is proportional to wealth,
ℓ(a, z) ∝ zλa); and a stationary consumption distribution (from Lemma 2, con-
sumption is proportional to wealth, c = ρa).31
Finally, even though wealth and consumption inequality explode asymptotically,
we can compute measures of aggregate welfare for any finite t.
Lemma 3: Welfare of workers and entrepreneurs at time t is given by

_ _ _
(24) Vt = (1 − Θ)V 
Et  + Θ V  W
t 
_
∫ ( ∫ )
∞ ∞
V  Et  =  _
1
ρ       v (z, t) ψt (z) dz +        log (a) φt (a) da
0 0
∫     e−ρ(s−t)  log [ws L] ds,

_ ∞
t  =
V  W
t
30
This note is available through my website http://www.princeton.edu/~moll/research.htm and directly at http://
www.princeton.edu/~moll/inequality.pdf.
31
The extension in Moll (2012) also generates two substantive results. First, I prove that the wealth distribution
has a Pareto tail as is common for random growth processes with death (see for example section 3.4.2. in Gabaix
2009), and as also seems to be relevant empirically (see for example Gabaix 2009; Benhabib, Bisin, and Zhu 2011;
and Blaum 2012). Second, tail inequality is a hump-shaped function of financial development and hence GDP,
meaning that it follows a Kuznets curve.
here Θ is the Pareto weight of workers and where v(z, t) satisfies the partial dif-
w
ferential equation (A10) in the Appendix.
_
Importantly, (24) provides an easily computable formula for time zero welfare,  V0 .
This allows me to study in a meaningful way parameter variations that differentially
affect the economy’s steady state and transition dynamics, in particular changes
in the persistence of idiosyncratic productivity shocks. The last term in (24) is the
welfare of workers. The sum of the first two terms is the aggregate welfare of entre-
preneurs. Because of the assumption of logarithmic utility, aggregate entrepreneur-
ial welfare conveniently separates into a part that summarizes the future evolution
of idiosyncratic productivities and factor prices, and another part that summarizes
wealth inequality.
II. The Importance of Persistence
The main purpose of this section is to illustrate the role played by the persistence
of productivity in determining productivity losses from financial frictions, both in
steady state and during transitions. I show that steady-state TFP losses are small
when shocks are persistent and vice versa; and next that the case with persistent
shocks and small steady-state TFP losses is precisely the case in which transitions
to steady state are typically very slow.
A. Definition of Persistence
I work with a relatively general notion of persistence. In particular, consider pro-

ductivity processes of the form:
_
(25) ˜ (z)dt + √1/θ   σ˜(z)dW.
dz = (1/θ) μ
This is (20) but with the drift and diffusion scaled by 1/θ. The parameter θ > 0 gov-
erns the persistence of the process. To see this consider first an example where the
logarithm of productivity follows an Ornstein-Uhlenbeck process
_
(26) d log z = − (1/θ) log z dt + σ√1/θ  dW,
where in addition to θ, also σ is a positive parameters. An attractive feature of this

process is that it is the exact continuous-time equivalent of a discrete-time AR(1)
process and it will also be the process that I use in my numerical exercises below.
The autocorrelation of this process is (see e.g., Dixit and Pindyck 1994):
corr(log z(t), log z(t + s)) = e−(1/θ)s

∈ (0, 1].
Two intuitive observations can be made. First, the autocorrelation is smaller the bigger
is the distance in time between the two observations, s. More importantly, the auto-
correlation is a monotone transformation of θ, which is therefore also a measure of
persistence. Taking the limit as θ → 0, we obtain corr[ log z(t), log z(t + s)] = 0. This
limit therefore corresponds to the case where productivity shocks are i.i.d. over time.
Some additional key properties of (26) are as follows: the stationary distribution
is log normal with mean zero and variance σ 2/2:
σ 2
( ) (
(log z)
)
2
log z ∼ N 0,  _   ψ(z) ∝  _ _
1
(27) ⇔ z  exp −   σ 2   .
2
Importantly, note that the stationary distribution does not depend on θ. This is
because θ scales both the drift and the diffusion (the innovation variance) of (26)
in such a way that the stationary productivity distribution ψ(z), and in particular its
variance, are held constant.32
These observations can be generalized from the Ornstein-Uhlenbeck process
(26), to any ergodic productivity process (25). In particular, in the limit as θ → 0,
productivity shocks are i.i.d. over time. Conversely, in the limit as θ → ∞, produc-
tivity is fixed for each individual z(t) = z0 . Further, note that varying θ does not
affect the stationary productivity distribution and in particular its variance.33 Instead
θ governs how quickly individuals churn around in the stationary productivity dis-
tribution. The same notion of persistence of an ergodic stochastic process is also
used in mathematical finance (Fouque et al. 2011), where θ is also called the time
scale of the process, with a short time scale (low θ) corresponding to low persistence
or fast mean reversion.
Throughout this section I also make Assumption 1, in particular that productiv-
_
ity has an upper bound z . This assumption serves two purposes. First and as in
Proposition 3, it is sufficient to examine the behavior of the wealth shares ω(z) on a
bounded interval. Second, the first best, namely allocating all resources to the most
productive entrepreneur, is well defined.
B. The Effect of Persistence on Steady States
The effect of persistence θ on steady-state variables can be characterized tightly.

The key is that the differential equation characterizing the stationary wealth shares
can be written as
1 d 2 2
0 = θs(z) ω(z) −  _ [  μ˜(z) ω(z)] +  _   _2 [ σ
d
(28)   ˜ (z) ω(z) ].
dz 2 dz
32
The following example should clarify: suppose instead that (the logarithm of) productivity follows a discrete
time AR(1) process, log zt= ρ log zt−1   + σεt . The stationary distribution of this process is a normal distribution with
mean zero, and variance _   σ   2 . The analogous experiment is then to vary ρ while holding constant  _ σ   2 . I prefer
2
1 − ρ  1 − ρ  2
this experiment to varying ρ in isolation for two reasons. First, this is the experiment for which it is possible to
obtain tight theoretical results. Second, the most related quantitative work conducts the same experiment so it makes
comparison to the existing literature easier (Buera and Shin 2011, 2013). Also in Midrigan and Xu (2014) it is criti-
cal what fraction of the cross-sectional variance of productivity is accounted for by the permanent and transitory
components: i.e., whether productivity is closer to being fixed or i.i.d. time.
33
To see this, consider the Kolmogorov Forward Equation for the stationary productivity distribution ψ(z) :
1 d  2
0 = −  _ [(1/θ) μ
˜ (z) ψ(z)] +  _   _  [(1/θ) σ ˜ 2(z) ψ(z)].
d
dz 2 dz  2
One can cancel θ from the right-hand side so the solution to the differential equation does not depend on it.
One can then analyze the effect of θ on the solution to the differential equation,
but without actually solving it. The following proposition states the paper’s main
steady-state result.
Proposition 4: For any ergodic productivity process (25) satisfying Assumption 1

_
and 0 <  σ˜(z) < ∞ for all z ∈ (0, z ), and for any 1 ≤ λ < ∞, stationary total fac-
tor productivity Z(θ) = 피ω(·, θ)[ z | z ≥ z_ ]αis continuous and strictly increasing in
persistence θ, with
_
Z(0) = 피[ z | z ≥ z_ ]α and  
lim Z(θ) = z  α ,
θ→∞
here 피[ ⋅ ] is the simple expectation taken over the stationary productivity distribu-
w
_
tion ψ, and z  α is the first-best TFP level.
In order to give some theoretically meaningful units to TFP numbers, I normalize

_
them by the first-best TFP level, z  α .34 The proposition then states that TFP losses are
smaller the more persistent are productivity shocks. The intuition behind this result
is best conveyed graphically. Figure 1, which is computed under the assumption
that productivity follows the Ornstein-Uhlenbeck process, plots the wealth shares
ω(z) relative to the distribution ψ(z) for different values of corr[ log z(t), log z(t + 1)]
= exp(− (1/θ)) and a given λ. The parameters are described in online Appendix E.
Two observations can be made: First, the wealth shares ω(z) generally place more
mass on higher productivity types (in the sense of first order stochastic domi-
nance). This is because for any positive autocorrelation, there is some scope for
self-financing so that higher productivity types accumulate more wealth. Second,
wealth is more concentrated with higher productivity types, the higher is the auto-
correlation of productivity shocks. To restate the same point in a slightly different
manner, note that
ω(z) → ψ(z) as θ → 0 (so that corr → 0).
Taking the limit as the autocorrelation goes to zero implies that we are in an environ-
ment where shocks are i.i.d. over time. In this case, and as discussed in Section II,
wealth and productivity will be independent and hence ω(z) = ψ(z). As we increase
the autocorrelation of productivity shocks above zero, self-financing becomes more
and more feasible and wealth becomes more and more concentrated among high
productivity types. Only relatively persistent shocks allow for wealth accumulation
and hence for self-financing to function as a substitute to credit access.
To further illustrate Proposition 4, Figure 2 graphs TFP against the par
ameter capturing the quality of credit markets, λ, and autocorrelation,
corr(log z(t + 1), log z(t)) = e−(1/θ)
. Panel A displays a three-dimensional graph,
and panel B the corresponding cross-section of TFP plotted against λ for selected
autocorrelations. Three observations can be made. First, TFP losses are smaller
the more correlated are productivity shocks. Second, TFP is a very steep function
34
I prefer this strategy to the alternative of normalizing TFP numbers by the TFP level for a high value of λ (say
ten) for the reasons discussed in online Appendix E.E3.
Panel A. Corr = 0.5 Panel B. Corr = 0.8

ψ(z) ψ(z)
0.7 0.7
ω(z)
0.6 0.6
0.5 0.5
0.4 0.4
0.3 0.3
ω(z)
0.2 0.2
0.1 0.1
0 0
0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 0 0.5 1.0 1.5 2.0 2.5 3.0 3.5
z z
Panel C. Corr = 0.95 Panel D. Corr = 0.99

ψ(z) ψ(z)
0.7 0.7
0.6 0.6
0.5 0.5
ω(z)
0.4 0.4
0.3 ω(z) 0.3
0.2 0.2
0.1 0.1
0 0
0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 0 0.5 1.0 1.5 2.0 2.5 3.0 3.5
z z
Figure 1. Wealth Shares and Autocorrelation
Notes: The dashed lines are the productivity distribution ψ(z) from (27). The solid lines are the wealth shares ω(z):
i.e., the solution to (22) for the stochastic process (26). As persistence θ (equivalently autocorrelation) increases,
wealth becomes more concentrated with high-productivity entrepreneurs.
of autocorrelation for high values of the latter. Third, the same is not true for low
values of autocorrelation for which TFP is relatively flat (that is, TFP is convex as
a function of autocorrelation). The steepness of TFP for high values of autocorrela-
tion potentially allows for a reconciliation of some of the very different quantitative
results in the literature (Buera, Kaboski, and Shin 2011; Midrigan and Xu 2014). I
comment on this in detail in online Appendix H.
As a brief aside, I would like to note that for alternatives to the Ornstein-Uhlenbeck
process (26) and in the extreme case of no capital markets, λ = 1, the differential
equation for stationary wealth shares (22) can actually be solved in closed form. I
provide two such closed-form examples in Appendix I. These examples work with
unbounded productivity processes. The results regarding the persistence of shocks
are qualitatively unchanged which demonstrates that they do not depend on the
boundedness of the productivity process in Assumption 1.35
35
Unfortunately, it is not possible to obtain closed-form solutions for the more general case, λ > 1, or for
the transitions. Also, the stochastic processes under which closed-form solutions can be obtained are empirically
somewhat less plausible and harder to link to existing empirical estimates than the process (26). For instance, they
are processes on the level rather than the logarithm of productivity. So as not to switch between different stochastic
Panel A Panel B
1.00
0.95 Corr = 0.99
0.95 0.90 Corr = 0.5

0.90 Corr = 0.9
0.85 0.85
TFP
TFP
0.80
0.80 Corr = 0
0.75
0.70
0.65 0.75
1.0 0.70
10
0.5 8
6 0.65
4
Corr 0 2 λ 1 2 3 4 5 6 7 8 9 10
λ
Figure 2. TFP and Autocorrelation
Notes: Panel B displays a cross-section of the three-dimensional graph in panel_

A. Again, note the sensitivity
in the range corr = 0.75 to corr = 1. Parameters are α = 1/3, ρ = δ = 0.05, σ√− log(0.85)  = 0.56, and I vary
corr = exp(− (1/θ)).
The main purpose of this section has been to illustrate the role of the persis-
tence of productivity shocks for steady-state capital misallocation and hence for
TFP losses from financial frictions. I have demonstrated that even with no capital
markets λ = 1 the first-best capital allocation is attainable if productivity shocks are
sufficiently persistent over time. Conversely, steady-state TFP losses can be large if
shocks are i.i.d. over time or close to that case.
C. The Effect of Persistence on Transition Dynamics
Having examined how steady-state productivity losses from financial frictions

depend on the persistence of productivity shocks, I now turn to the transition
dynamics of the model. A deeper understanding of transition dynamics allows one
to answer questions such as: if a developing country undertakes a reform, how long
do its residents need to wait until they see tangible results and what factors does this
depend on? Related, transitions in models of financial frictions have the potential
to explain observed growth episodes such as the postwar miracle economies (Buera
and Shin 2013). I argue in this section that, if shocks are relatively persistent so
that financial frictions are unimportant in the long-run steady state, they instead
considerably slow down the transition to steady state. This is because self-financing
takes time and results in the joint distribution of ability and wealth and therefore
TFP evolving endogenously over time. Conversely, transitory shocks result in large
long-run productivity losses but a fast transition. Furthermore, if the initial joint dis-
tribution of productivity and wealth is sufficiently distorted, the case with persistent
shocks and hence small long-run TFP losses, also turns out to be the case with large
short-run TFP losses. My results are numerical. I would, however, like to emphasize
processes in the main text, I relegated the closed-form examples to online Appendix I. Readers with a preference
for closed-form solutions should still find them appealing.
that solving for an equilibrium boils down to solving a single partial differential
equation, (21). This can be done very efficiently and I therefore view my approach
as an improvement over existing techniques for computing transition dynamics in
this class of models. See the discussion in footnote 6. My numerical algorithm is
described in online Appendix J.
I here present three transition experiments. The first experiment follows Buera
and Shin (2013) and computes transitions after a reform eliminates idiosyncratic
distortions. In the prereform steady state, firms face idiosyncratic distortions (in
addition to financial frictions) which are positively correlated with firm-level pro-
ductivity as in Restuccia and Rogerson (2008). A reform removes these distortions
and triggers a transition. Details are in online Appendix K. Buera and Shin (2013)
have argued that these types of transitions capture many features of the growth expe-
riences of postwar miracle economies. The second and third experiments are simply
transitions from an exogenously given initial joint distribution of ability and wealth,
as summarized by the corresponding wealth shares, ω0(z). I find it convenient to
parameterize the initial wealth shares as
(29) _1 (log z − m)2

_
ω0(z) ∝   z  exp −        .
σ 2
( )
This is the formula for a log normal distribution with mean m and variance σ 2/2.
With m = 0, this is also the stationary distribution of the Ornstein-Uhlenbeck pro-
cess (27), ω 0(z) = ψ(z), meaning that wealth and ability are independent of each
other at time zero. With m > 0, wealth shares place more mass on high-ability types,
which is to say that wealth and ability are positively correlated. My second transi-
tion experiment starts with a distorted initial allocation, in which wealth and ability
are negatively correlated (m = − 0.5) and my third experiment instead starts from
a relatively undistorted allocation (m = 0.25). In all experiments, I use the same
parameters as in the preceding section and additionally set λ = 1.2, consistent with
the external-finance-to-GDP ratio for India (see online Appendix Table E1).
The main result of this section is summarized in Figure 3 which plots the speed
of these three types of transitions, as measured by the half-life of the TFP transition
(i.e., the number of years until TFP has converged halfway to its new steady-state
level) for different values of persistence. The figure shows that, regardless of the
specific transition experiment, transitions are slower the more persistent are pro-
ductivity shocks.36 The result holds unless TFP starts out exactly at its steady-state
level in which case there are no dynamics and hence the half-life is zero.37 The
result holds both in cases in which TFP is increasing toward its steady state and if
it is decreasing.
36
The half-lives of the TFP transition are relatively short for empirically plausible values of persistence. But
even transitions with a TFP half-life of only 4–7 years trigger prolonged capital transitions with half-lives of
15–25 years, consistent with the empirical evidence in Buera and Shin (2013).
37
In the figure, I do not report experiments in which TFP starts out exactly at its steady-state value. Neither do I
report experiments where the economy starts out extremely close to its steady-state because numerically computing
the half-life of the transition becomes exceedingly difficult. This is for example an issue in the third experiment
starting from wealth shares (29) with m = 0.25 (line with crosses) for values of persistence between 0.75 and 0.82.
Experiments 1: Distortionary taxes

7 Experiments 2: m = −0.5
Experiments 3: m = 0.25
Half-life of TFP transition (in years)
0
0 0.2 0.4 0.6 0.8 1
Corr
Figure 3. Effect of Autocorrelation on Speed of Transition
To examine this result in more detail, Figure 4 displays the second transition
experiment: i.e., starting from initial wealth shares given by with (29) m = − 0.5.
For now, consider only the TFP transitions in panel A. Transitions are more pro-
tracted the more persistent are productivity shocks. With persistent shocks, the
model generates persistent endogenous TFP dynamics while with i.i.d. shocks, TFP
jumps immediately to its steady-state value.38
To understand the effect of persistence on TFP dynamics in Figures 3 and 4, it
is instructive to examine the evolution of the wealth shares ω(z, t). Figure 5 plots
these for two values of the autocorrelation, corr = 0 and corr = 0.97. With i.i.d.
shocks (panel A), productivities are reshuffled instantaneously and wealth shares
jump to their steady-state value (see footnote 39). That is, wealth shares and hence
TFP do not change any more after time zero. While convergence is instantaneous,
wealth and ability are independent of each other in this steady state, resulting in a
relatively distorted allocation and a low level of TFP. In contrast, with persistent
shocks, wealth shares continue to change for a long time. Over time, they place
more and more mass on higher-productivity types—i.e., wealth gets more and more
concentrated among these high-productivity types. Finally, wealth shares converge
to their steady state in which wealth and productivity are positively correlated. It
takes a long time to attain this more efficient allocation because initial misallocation
unwinds only slowly. Since TFP depends only on the wealth shares and the quality
38
With i.i.d. shocks, wealth and productivity are immediately independent of each other (see section IF). This
implies that wealth shares jump to ω(z, t) = ψ(z), the stationary productivity distribution. See panel A of Figure 5
below. In turn, TFP jumps immediately to its long-run level of E [ z | z ≥ z_ ]: i.e., a simple unweighted average of
the productivities of active entrepreneurs.
Panel A. TFP Panel B. Capital stock

1.6
0.80
1.5
Corr = 0.97
0.75 Corr = 0.97
1.4
Corr = 0.85 Corr = 0.85
0.70 1.3
1.2
0.65 Corr = 0 Corr = 0
1.1
0.60
1.0
0 5 10 15 20 25 30 0 10 20 30 40 50 60
Years Years
Panel C. GDP Panel D. Interest rate

1.6 −0.010
−0.012 Corr = 0.97
1.5
Corr = 0.97 −0.014
1.4 −0.016
Corr = 0.85
−0.018
1.3
−0.020
1.2 −0.022 Corr = 0.85
Corr = 0
−0.024
1.1 Corr = 0
−0.026
1.0 −0.028
0 10 20 30 40 50 60 0 10 20 30 40 50 60
Years Years
Figure 4. Transition Dynamics from Distorted Initial Wealth Distribution
Notes: Parameter values are α = 1/3, ρ = δ = 0.05, and λ = 1.2, consistent with the external-finance-to-GDP
_ ratio
for India (see Table E1). For the benchmark exercise, I use corr = exp(−(1/θ)) = 0.85 and σ√1/θ  = 0.56. The
lines for corr = 0 and corr = 0.97 vary θ while holding constant var(log z) = σ 2/2. Initial wealth shares are given
by (29) with m = − 0.5.
of credit markets, the slow dynamics of wealth shares immediately translate into
slow TFP dynamics.
Apart from the speed of transitions, the TFP time paths in panel A of Figure 4
have a second noteworthy feature: while TFP losses are smaller in the long run the
more persistent are productivity shocks, they are actually larger in the short run.
This is an immediate corollary of the result that transitions are slower the more
persistent is productivity: if the initial joint distribution of productivity and wealth
is sufficiently distorted (as in the present experiment where initial wealth shares
are given by (29) with m = − 0.5), the TFP time paths for different values of per-
sistence cross. Intuitively, larger short-run TFP losses with persistent shocks arise
because the initial misallocation takes longer to unwind. Of course, this relies on the
initial condition and is not necessarily the case. To illustrate this point, Figure K2 in
Appendix K displays transition dynamics from relatively undistorted initial wealth
shares, (29) with m = 0.25. Note that, even if time paths for TFP no longer cross
with relatively undistorted initial wealth shares, it is still true that TFP dynamics are
more prolonged the more persistent are shocks.
Finally, consider the transition dynamics of other aggregates: the capital stock,
GDP and the interest rate in panels B to D of Figure 4. Their dynamics are simply
Panel A. Wealth shares, corr = 0
1.0
0.8
ω(z, t)
0.6
0.4
0.2 30
20
0 10 t
0 1 2 3 0
4
z
Panel B. Wealth shares, corr = 0.97
1.0
0.8
ω(z, t)
0.6
0.4
0.2 30
20
0 10 t
0 1 2 3 0
4
z
Figure 5. Transition Dynamics for Wealth Shares
Notes: Panel A displays transition dynamics for corr = 0, and panel B for corr = 0.97. With corr = 0, wealth shares
jump immediately to their steady-state value which is just the stationary distribution of productivity shocks ψ(z),
implying that productivity and wealth are independent in the cross-section. After time zero, wealth shares and hence
TFP do not change anymore. In contrast, with corr = 0.97 wealth shares continue to change for a long time. Over
time, they place more and more mass on higher productivity types: i.e., wealth gets more and more concentrated
among these high-productivity types. Finally, wealth shares converge to their steady state in which wealth and pro-
ductivity are positively correlated. Since TFP depends only on the wealth shares and the quality of credit markets,
the slow transition of wealth shares immediately implies a slow transition of TFP.
those that would arise in a standard growth model with exogenous TFP following
the time paths in panel A. For instance, consider the dynamics of the interest rate
in panel D. With i.i.d. shocks, TFP jumps immediately to its steady-state value and
hence interest rate dynamics are qualitatively identical to those in a growth model
following a one-time permanent TFP increase: the interest rate declines monotoni-
cally throughout the transition. In contrast, with persistent shocks, TFP grows over a
prolonged time period and hence the interest rate rises during early stages of the tran-
sition.39 King and Rebelo (1993) have argued that a neoclassical growth model with
constant (or no) exogenous TFP growth has no hope of explaining sustained growth
as stemming from transitional dynamics. In particular, one generates extremely
counterfactual implications for the time path of the interest rate. According to their
calculations, if the neoclassical growth model were to explain the postwar growth
experience of Japan, the interest rate in 1950 should have been around 500 per-
cent. In contrast, Chen, Imrohoroglu, and Imrohoroglu (2006, 2007) argue that the
neoclassical growth model is, in fact, consistent with the Japanese postwar growth
experience once one takes as given the time-varying TFP path measured in the data.
The time path for TFP in panel A of Figure 4 that my model with persistent shocks
generates endogenously is, in fact, broadly similar to the exogenous time path that
Chen, Imrohoroglu, and Imrohoroglu feed into their neoclassical growth model.40
But note that only the version of the model with persistent shocks can generate these
dynamics whereas the version with i.i.d. shocks cannot.
D. Welfare
If the persistence of productivity shocks affects TFP and GDP losses differen-
tially in steady state and during transitions, one may ask how these effects should
be balanced against each other. The welfare measure in Lemma 3 provides a natu-
ral metric. Figure 6 plots various welfare measures relative to their first-best val-
ues against autocorrelation. These welfare numbers are in permanent consumption
equivalents.41 The_ initial wealth shares are those from Figure 4. Panel A plots wel-
    W
fare of workers, V 0  , against autocorrelation for two values of the discount rate ρ.
Because workers’ welfare simply equals the present discounted value of wages and
wage payments are a constant fraction of GDP, it simply trades off the short run and
the long run of the GDP time paths in panel C of Figure 4. For reasonable values
of the discount rate ρ, the long run dominates and workers’ welfare is an increasing
39
This is a statement about the slope of the interest rate time path; still some readers may wonder about its level,
namely why real interest rates are negative. Interest rates are bounded below by − δ and negative real interest rates
due to depressed credit demand are a common feature of models with collateral constraints (Buera and Shin 2013;
Buera, Kaboski, and Shin 2011; Guerrieri and Lorenzoni 2011). The particular form of the borrowing constraint (4)
does matter. For instance, negative interest rates are less likely to occur if the maximum leverage ratio is decreasing
in the interest rate as in the extension in Appendix D (equation (D4)). Even with the constraint (4), many alternative
parameterizations feature positive interest rates.
40
See Table A1 in Chen, Imrohoroglu, and Imrohoroglu (2006) and Figure 9 in Chen, Imrohoroglu, and
Imrohoroglu (2007) for the TFP growth rates they feed into their model. As in panel A of Figure 4 for the case
corr = 0.97, the Japanese TFP growth rate starts out positive in 1956 and then converges to zero toward 2000. My
model has no aggregate uncertainty so cannot generate the deviations from trend that are features of the Japanese
TFP time-path. But the underlying trend is similar to that generated by my model in terms of both magnitude and
speed of transition. _ _
_
41
That_is, consider V   t defined in (24).
_ _ By permanent _ consumption
_   0 satisfying
equivalents I mean C
  0  = log( C0)/ρ so that Figure 6 reports C 0  = exp[ρ(  V0  −  V  0    )].
  0/ C  FB FB
V
Panel A. Welfare of workers Panel B. Welfare of entrepreneurs
0.74 0.75
Welfare relative to first−best

0.72 0.70
ρ = 0.1
0.70
0.65
0.68 ρ = 0.05
0.60
0.66
0.55
0.64
0.50
0.62
ρ = 0.05
ρ = 0.1
0.60 0.45
0.58 0.40
0 0.2 0.4 0.6 0.8 1 0 0.2 0.4 0.6 0.8
corr corr
Panel C. Total welfare with worker Panel D. Total welfare with worker
weight, Θ = 0.5 weight, Θ = 0.7
0.65 0.66
ρ = 0.1
0.65
0.64
ρ = 0.05 0.63 ρ = 0.1

0.6
0.62
0.61
ρ = 0.05
0.60
0.55 0.59
0 0.2 0.4 0.6 0.8 0 0.2 0.4 0.6 0.8 1
corr corr
Figure 6. Welfare Losses
Notes: Parameter values are α = 1/3, δ = 0.05, and λ = 1.2, consistent with the external-finance-to-GDP
ratio for India (see Table E1), and I vary corr = exp(−(1/θ)) while holding constant var(log z) = σ 2/2
= (0.56)2/(− 2log(0.85)) = 0.96. Initial wealth shares are the same as in Figure_4 and _ given by_(29) _with
m = −_0.5. Welfare relative to first-best is in units of permanent consumption: C 0  = exp[ρ(  V0  −  V  0    )]
  0/ C  FB FB
where  V0is defined in (24).
function of autocorrelation. But this relationship is flatter when workers _ are more
myopic (higher ρ). Panel B shows that entrepreneurial welfare, V
42
    0  is a (barely)
E
hump-shaped function of autocorrelation in the case where ρ = 0.05. This result

has been discussed in detail by Buera and Shin (2011) and is due to two offsetting
effects: on one hand, more persistent shocks lead to higher total factor productivity
and hence higher returns to capital; on the other hand, more _ persistent shocks are
harder to self-insure.43 Panels C and D plot overall welfare  V0for two different val-
ues of the Pareto
_ weight _ Θ that the planner places on workers: i.e., simple weighted
    W
averages of V  0 and  V  E0  in panels A and B. Depending on the Pareto weight, the
42
For extremely high values of the discount rate ρ, and given a distorted initial allocation as in the present exer-
cise, workers’ welfare can be a decreasing function of autocorrelation because the high short-run GDP losses with
persistent shocks outweigh the low steady-state losses.
43
See Figure 1 in Buera and Shin (2011) which closely resembles my Figure 6 and the surrounding discussion.
shape of overall welfare as a function of persistence can be extremely different.

Summarizing, the effect of persistence on overall welfare is ambiguous depending
on the discount rate and the Pareto weights of workers and entrepreneurs.
E. Summary of Results
To summarize, consider the behavior of my model with a persistence parameter

in the empirically relevant range: i.e., with an autocorrelation of, say, 0.75 to 0.97
(Gourio 2008; Asker, Collard-Wexler, and De Loecker forthcoming). With such a
level of persistence, financial frictions can matter in both the short and the long run.
In the long run, self-financing partly undoes capital misallocation and hence reduces
TFP losses; but the steepness of steady-state TFP for high values of autocorrela-
tion (see Figure 2) means that even relatively persistent shocks can lead to sizable
steady-state TFP losses. At the same time, financial frictions provide a theory of
endogenous TFP dynamics that result in prolonged transitions to steady state for
capital and GDP. In contrast, the empirically irrelevant extremes of fixed productivi-
ties and i.i.d. shocks are potentially misleading but for completely different reasons:
with fixed productivities, self-financing completely undoes all capital misallocation
in the long-run and TFP is first-best; in contrast, with i.i.d. shocks the model gener-
ates no endogenous TFP dynamics as TFP jumps immediately to its steady-state
value. Finally, in the empirically relevant range, financial frictions result in welfare
losses for both workers and entrepreneurs, and higher persistence makes workers
better off but entrepreneurs worse off so that the overall effect is ambiguous.
III. Sensitivity to Functional Form Assumptions
To deliver my model’s tractability, I have assumed that entrepreneurs have loga-

rithmic utility functions and operate constant returns to scale production functions.
The purpose of this section is to briefly discuss to what extent these twin restrictions
on preferences and technology can be relaxed. All detailed derivations, proofs, and
computations are in online Appendix D.
Logarithmic Utility.—It is natural to ask whether results generalize to the case

where entrepreneurs have constant relative risk aversion (CRRA) utility functions.44
First, the representation of aggregate GDP in terms of an aggregate production
function (11) and the formula for TFP (13) follow from firms’ profit maximization
behavior only and so are unchanged. What does change is entrepreneurs’ savings
behavior (Lemma 2), but I now show that Propositions 1 and 2 still go through with
slight modification. To see this, note that with CRRA utility with parameter γ, say,
entrepreneurs still consume a constant fraction of their wealth, c =  ˜c(z, t; γ, λ)a, but
44
One may also ask whether results generalize beyond the CRRA case (say to the hyperbolic absolute risk aver-
sion (HARA) class of utility functions). This extension would require a purely numerical solution and most tracta-
bility would be lost. The reason is that with rate of return risk as in the present paper, only the CRRA utility function
delivers consumption policy functions that are linear in wealth (Carroll and Kimball 1996). And this is exactly what
allows individual savings rules to be aggregated. However, note that CRRA utility is the standard assumption made
by the entire quantitative literature discussed in the introduction.
this marginal propensity to consume is no longer constant across productivity types.

˜ (z, t; 1, λ) = ρ. Further, define by
In the special case of log utility,  c
∫     c˜ (z, t; γ, λ) ω(z, t) dz

∞
(30)  ˜ρ(t; γ, λ) =
0
the aggregate marginal propensity to consume out of wealth. Proposition 1 then goes
through with one modification only, namely that we need to replace ρ by  ρ(t; ˜ γ, λ)
in equation (12). Similarly, in Proposition 2 only the definition of the savings rate
needs to be changed to reflect the changed marginal propensity to consume.45
With these modified propositions in hand, we can now examine the robust-
ness of the paper’s main results to departures from log utility. First, my economy
still aggregates to a Solow model, however now with a time-varying depreciation
rate,   δ  (t; γ, λ) =  ˜ρ(t; γ, λ) + δ, that potentially depends on financial development
λ. As a corollary, consider the result from Section I that financial frictions affect
aggregate savings only through TFP. In general, this is no longer true with CRRA
utility. To see this clearly, consider the expression for the steady-state capital to out-
put ratio (19) which becomes
α
 _  =  _
K
    .
Y  ρ(γ,
˜ λ) + δ
Because in general the aggregate marginal propensity to consume ρ  (γ,

˜ λ) depends
on λ, so does K/Y. While the result is therefore exact only for logarithmic utility,
it turns out that the capital to output ratio does not change much with λ as long
as γ is close to 1. Put differently, things are continuous in γ. To make this point, I
have computed numerical examples in which I vary λ over the empirically plausible
range from 1 to 4.15 (the latter corresponding to my estimate for the United States,
see online Table E1) and then examine changes in K/Y for different values of γ. For
γ = 2, K/Y changes by 8 percent; and for γ = 1/2, it changes by 3 percent only.
Furthermore, note that the direct effect of λ on aggregate savings is really due to
individual marginal utilities not being equalized under incomplete markets, rather
than marginal products not being equalized due to collateral constraints.46
Next, consider the result that steady-state TFP losses are strictly decreasing in
the persistence of productivity shocks, θ. In contrast to Proposition 4, it is no longer
possible to prove this result analytically.47 However, the result continues to hold in
all my numerical experiments, again using standard parameter values. Finally, also
45
That is, s  ˜ (z) ≡ λ max{zπ − r − δ, 0} + r −  ˜c (z; γ, λ) which generalizes s(z) in Lemma 2.
46
Consistent with this, and as in Angeletos (2007) who analyzes an economy without collateral constraints,
whether K/Y is greater or smaller than in the perfect credit/complete markets benchmark, α/(ρ + δ), depends on
γ. If γ < 1, the capital-output ratio is smaller; if γ > 1, it is larger. Similarly, K/Y is an increasing function of λ with
γ < 1 but a decreasing one with γ > 1. See also Buera and Moll (2012) who show how, in my framework with log
utility, individual Euler equations can be aggregated to an Euler equation for the representative entrepreneur, and
that with CRRA utility one picks up additional aggregation effects due to incomplete insurance.
47
This is because with the process (25), the marginal propensity to consume c  ˜ (z; γ, λ, θ) and hence the savings
rate s  ˜ (z) ≡ λ max{zπ − r − δ, 0} + r −  ˜c (z; γ, λ, θ) depend on θ, so that there is an additional effect which cannot
be signed in general.
the result that transitions are slow if shocks are persistent continues to hold with
CRRA utility with the same parameter values.
Constant Returns Technology.—Things change more substantially if I drop the

assumption that entrepreneurs operate constant returns to scale technologies. With
decreasing returns, individual firm size is no longer constrained by wealth only and
hence capital demand is no longer linear in wealth. This implies that it is no longer
possible to represent aggregate GDP in terms of an aggregate production function
as in (11) or to obtain a simple formula for TFP like (13). This being said, note that
everything is continuous in returns to scale. For example, with constant returns all
active firms are financially constrained; and with returns to scale slightly below 1,
almost all firms are constrained. Therefore the constant returns economy analyzed
in the present paper is simply the analytically tractable limiting case of a decreasing
returns economy. In Appendix G, I make this point more formally by assuming that
production functions are y = ((zk)α ℓ1−α
) , ν < 1 rather than (2) and by showing
ν
that many of my formulas for the production side of the economy can be obtained
by taking the limit as ν → 1.48 My paper analyzes the analytically tractable limiting
case of constant returns to scale, whereas most of the existing literature analyzes
the empirically more relevant but intractable case of decreasing returns. I view the
two approaches as complimentary.49 Standard values for ν are relatively close to
1,50 so there is some reason to believe that my results would continue to hold. In
line with this, the recent quantitative literature analyzing decreasing returns environ-
ments provides some illustrative calculations regarding the effect of persistence on
steady-state TFP losses that closely mirror my analytical results.51
IV. Concluding Remarks
In my framework, self-financing undoes capital misallocation from financial fric-

tions in the long run if idiosyncratic productivity shocks are relatively persistent.
The reason is that entrepreneurs accumulate wealth out of past successes so only if
high productivity episodes are sufficiently prolonged can they accumulate sufficient
internal funds to self-finance their desired investments. As a result, the extent of
steady-state capital misallocation and therefore TFP losses from financial frictions
are small with persistent shocks. However, the case in which steady-state productiv-
ity losses are small is precisely the case in which transitions to this steady state take
a very long time. This is because TFP endogenously evolves as capital misallocation
slowly unwinds over time. Conversely, if shocks are transitory, steady-state TFP
losses are large but the transition to this steady state is fast.
( ) 1−ν
_ _ α
z     
48
(ν) =  ∫  0   z1−ν ψ(z) dz  
Just to give an example, first-best TFP is a geometric mean of productivities Z FB
_
(ν) = max{z  α} =  z    α.
Z FB
which satisfies lim ν→1
49
The decreasing returns case is arguably more useful for studying firm-level facts—e.g., firm dynamics and size
distributions, and for a serious quantitative assessment of aggregate TFP losses from financial frictions.
50
For example, ν is 0.85 in Atkeson and Kehoe (2007) and Midrigan and Xu (2014), and 0.79 in Buera and
Shin (2013).
51
See Figure 2 in Buera and Shin (2011) showing that steady-state TFP losses are strictly decreasing in persis-
tence, and the robustness checks in Midrigan and Xu (2010, the working paper version). The robustness checks in
Buera and Shin (2013) suggest that also my transition results carry over to the decreasing returns case.
I have made this point in a heterogeneous-agent model with borrowing con-

straints and forward-looking savings behavior. While featuring rich heterogeneity,
the model remains highly tractable and TFP is simply a truncated weighted average
of individual productivities, where the weights are the shares of wealth held by dif-
ferent productivity types. Solving for an equilibrium boils down to solving a single
differential equation for these wealth shares (Proposition 2) which is a substantial
improvement over commonly used solution techniques. In contrast to similar exist-
ing theories, the model presented here also allows for persistent productivity shocks.
The self-financing mechanism that takes center stage in my paper implies that any
empirically serious theory of heterogeneous firms and financial frictions must fea-
ture such persistence. The tools presented in this paper, particularly Propositions 2
and 4, could therefore also prove useful in other applications.
Appendix: Proofs
A1. Proof of Lemma 1
From the profit maximization problem (5), optimal labor demand is ℓ

= (π/α)1/(1−α)
zk, where π is as in the lemma. Plugging back in, the profit
function becomes
Π(a, z) = max{zπk − (r + δ)k s.t. k ≤ λa}.

k
Since this problem is linear, it follows immediately that k is either zero or λa. The
cutoff _z is defined as the value for which entrepreneurs are indifferent between run-
ning a firm and being inactive, Π(a, z_) = 0.
From Lemma 1, we know that a  ˙ = A(z, t)a − c where A(z, t) = λ max{zπ(t) −
r(t) − δ, 0} + r(t). The Bellman equation is then (see Stokey 2009, ch. 2),
ρV(a, z, t) = max
c {
log c +  _   피 [ dV(a, z, t)]
1
dt
s.t. }
da = [ A(z, t) − c ]dt .
The proof proceeds with a guess and verify strategy. Guess that the value func-
tion takes the form V(a, z, t) = Bv(z, t) + B log a. Using this guess we have that
E [dV(a, z, t)] = (B/a)da + BE [dv(z, t)]. Rewrite the value function
log c +  _ _
B 1
ρBv(z, t) + ρB log a = max
c a  [ A(z, t)a − c ] + B   dt  피 [dv(z, t)].
Take first-order condition to obtain c = a/B. Substituting back in,
ρBv(z, t) + ρB log a = log a − log B + A(z, t)B − 1 + B _

1
    피 [dv(z, t)].
dt
Collecting the terms involving log a, we see that B = 1/ρ so that c = ρa

˙ = [A(z, t) − ρ]a as claimed. Finally, the value function is V(a, z, t) = [v(z, t)
and  a
+ log a]/ρ where v(z, t) satisfies
ρv(z, t) = ρ log ρ − ρ + A(z, t) +  _  피 [dv(z, t)].

1
(A1)
dt
A3. Proof of Proposition 1
Throughout this proof, I omit indexing by t for notational simplicity. Using the
expression for factor demands in Lemma 1, labor demand can be written as
ℓ(a, z) = ( _
  α   )
π 1/(1−α)
(A2) λaz, z ≥
_z,
and zero otherwise. It follows that individual output is y(a, z) = (π/α)λaz, if z ≥ _z ,
and zero otherwise. Aggregate output is then
Y = ∫    ∫    y(a, z) g(a, z) da dz =  _ ∫

∞ ∞
π ∞
(A3) α  λ XK, where X =     zω(z) dz
0 0 z_
is an auxiliary variable. Next, consider the labor market clearing condition (A2).
Integrating over all a and z,
L = ( _
  α   )
π 1/(1−α)
(A4) λ XK ⇔ π = α(λ X)α−1
K α−1
L1−α.
Substituting into (11), we see that Y = (λ XK)α L1−α

. Eliminating λ using (14) this
is (11) and (13) in the proposition.
Consider next the law of motion for aggregate capital (10). Using that the shares
ω(z) integrate to 1, we have that
  ˙
 _  = λ π ∫    zω(z) dz − λ(r + δ ) ∫
∞ ∞
K
    ω(z) dz + r − ρ.
K _z z_
Using capital market clearing (14),
˙
(A5)  _  = λ πX − (ρ + δ), X ≡ ∫    zω(z) dz.
∞
 K
K _z
Substituting (A4) into (A5) and rearranging, we get
˙ = αZKα L1−α
 K − (ρ + δ)K, Z = (λX)α .
After substituting for λ from (14), this is equation (12) in Proposition 1. Substituting
the definition of π from Lemma 1 into (A4) and rearranging yields the expression
for w. Substituting (A4) into the cutoff condition _zπ = R and rearranging yields
the expression for R.
A4. Proof of Proposition 2
The law of motion for the joint distribution of wealth is given by the Kolmogorov
Forward Equation (see for example Stokey 2009, p. 50).
∂g(a, z, t) ∂ ∂
(A6)  _   = −  _  [ g(a, z, t) s(z, t)a ] −  _  [ g(a, z, t) μ(z) ]
∂t ∂a ∂z
1 ∂ 2 2
+  _  _
    [ σ (z) g(a, z, t) ].
2 ∂ z2
Using the definition of ω(z, t) we have that
∂ω(z, t) ∂g(a, z, t)   ˙ (t)

=  _  ∫    a _
∞ K
(A7)  _   da −  _  ω(z, t).
1
   
∂t K(t) 0 ∂t K(t)
Using an integration by parts
− ∫    a _
    [ g(a, z, t) s(z, t)a ]da = s(z, t)∫    ag(a, z, t) da.
∞
∂ ∞
(A8)
0 ∂a 0
Plugging (A6) into (A7) and using (A8), we obtain the PDE (21). Setting the time
derivative equal to zero, one obtains the ODE (22). This proves all assertions in the
theorem except for continuity and differentiability, which require more work. Due
to space constraints these proofs are stated in online Appendix B3.
Welfare at time t is given by
(A9)  Vt = ( 1 − Θ ) ∫  V(a, z, t) dGt(a, z) + Θ ∫  e−ρ(s−t)

_ ∞
log[ w(s) L] ds.
t
From the proof of Lemma 2, the value function of an entrepreneur is V(a, z, t)

= [v(z, t) + log a]/ρ where v(z, t) satisfies (A1). Substituting into (A9) gives (24).
With the stochastic process (20), (A1) is
(A10) ρv(z, t) = ρ log ρ − ρ + λ max{zπ(t) − r(t) − δ, 0} + r(t)
∂v(z, t) 1 ∂ v(z, t) 2

2
∂ v(z, t)
+  _   μ(z) +  _  _
    σ (z) +  _   .
∂z 2 ∂ z
2 ∂t
A6. Proofs of Propositions 3 and 4
The proofs are long and mathematically involved and stated in online Appendix B.
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American Economic Review 2014, 104(10): 3186–3221

Productivity Losses from Financial Frictions:

I develop a highly tractable general equilibrium model in which

Underdeveloped countries often have underdeveloped financial markets. This can

is s­ ufficiently persistent. The efficacy of self-financing then translates directly into

My paper is most closely related and complementary to a series of more recent,

A. Preferences and Technology

Time is continuous. There is a continuum of entrepreneurs that are indexed by

피​0​​ ∫​ ​ ​​e−ρt

(2) y = f (z, k, ℓ) = (zk​)α​ ​ ​ℓ1−α

Entrepreneurs hire workers in a competitive labor market at a wage w(t). They

(3) ​ ˙a​ = f (z, k, ℓ) − wℓ − (r + δ)k + ra − c.

˙ equal profits—output minus payments to labor and capital—plus interest

This formulation of capital market imperfections is analytically convenient.

Entrepreneurs maximize the present discounted value of utility from consump­-

(5) Π(a, z) = ​max ​​{ f (z, k, ℓ) − wℓ − (r + δ)k s.t. k ≤ λa }​.

The interpretation is that entrepreneurs solve a static profit maximization problem

Π(a, z) = max{zπ − r − δ, 0} λa, π = α ​​ _ (

The productivity cutoff is defined by _​z​π = r + δ.

​ ˙a​ = ​[ λ max {zπ − r − δ, 0} + r ]​a − c.

Lemma 2: The optimal savings policy function is linear in wealth

(6) ​ ˙a​ = s(z)a, where s(z) = λ max {zπ − r − δ, 0} + r − ρ

is the savings rate of productivity type z.

D. Equilibrium and Aggregate Dynamics

(7) ∫​ ​​kt​​(a, z) d​Gt​​(a, z) = ​∫​ ​a d​Gt​​(a, z),

(8) ∫​ ​​ℓt​​(a, z) d​Gt​​(a, z) = L.

The goal of this subsection is to characterize such an equilibrium. The following

ω(z, t) ≡ ​ _ ​ ​∫​ ​ ​a​g​t​(a, z) da,

∫​ ​ ​ ω(x, t) dx.

λ(1 − Ω( ​_z​, t)) = 1.

˙ (t) = ​∫​ ​ ​s(z, t) ω(z, t) dzK(t)

∫​ ​ ​ ​[ λ max {zπ(t) − r(t) − δ, 0} + r(t) − ρ ]​ω(z, t) dzK(t).

Using similar manipulations, we obtain our first main result.

(11) Y = Z​Kα​ ​​L1−α

where K and L are aggregate capital and labor and

(13) Z(t) = ​​ __ ​ ​​ ​ = ​피ω,

is measured TFP. The productivity cutoff ​z_​is defined by

(14) λ(1 − Ω( ​_z​ , t)) = 1.

Factor prices are

The interpretation of this result is straightforward. In terms of aggregate

˙ ≡ ​ s ​Y − ​ δ ​K,

capital αZ​Kα−1 ​ ​ ​L1−α

A steady-state equilibrium is a competitive equilibrium satisfying

Imposing these restrictions in Proposition 1 yields the following immediate corollary.

Corollary 1: Given stationary wealth shares ω(z), aggregate steady-state

where K and L are aggregate capital and labor and

F. The Evolution of Wealth Shares

It follows immediately that TFP Z(t) → max{z​}​α​as t → ∞. Steady-state TFP and

of this result is that, asymptotically, self-financing completely undoes all capital

(20) dz = μ(z)dt + σ(z)dW.

he stationary wealth shares must also be nonnegative, bounded, continuous, and

Assumption 1: The productivity process (20) is either naturally bounded or it is

Proposition 3: For any ergodic productivity process (20) satisfying

ω(z) ≡ ​ _ ​ ​∫​ ​ ​a​g​t​(a, z) da.

Lemma 3: Welfare of workers and entrepreneurs at time t is given by

∫​ ​ ​ ​e​−ρ(s−t)​ log [​ws​​ L] ds,

II. The Importance of Persistence

I work with a relatively general notion of persistence. In particular, consider pro-

is s ufficiently persistent. The efficacy of self-financing then translates directly into

피0 ∫    e−ρt

(2) y = f (z, k, ℓ) = (zk)α ℓ1−α

(3)  ˙a = f (z, k, ℓ) − wℓ − (r + δ)k + ra − c.

Entrepreneurs maximize the present discounted value of utility from consump-

(5) Π(a, z) = max { f (z, k, ℓ) − wℓ − (r + δ)k s.t. k ≤ λa }.

Π(a, z) = max{zπ − r − δ, 0} λa, π = α _ (

The productivity cutoff is defined by _zπ = r + δ.

 ˙a = [ λ max {zπ − r − δ, 0} + r ]a − c.

(6)  ˙a = s(z)a, where s(z) = λ max {zπ − r − δ, 0} + r − ρ

(7) ∫  kt(a, z) dGt(a, z) = ∫  a dGt(a, z),

(8) ∫  ℓt(a, z) dGt(a, z) = L.

ω(z, t) ≡  _  ∫    agt(a, z) da,

∫    ω(x, t) dx.

λ(1 − Ω( _z, t)) = 1.

˙ (t) = ∫    s(z, t) ω(z, t) dzK(t)

∫    [ λ max {zπ(t) − r(t) − δ, 0} + r(t) − ρ ]ω(z, t) dzK(t).

(11) Y = ZKα L1−α

(13) Z(t) = __       = 피ω,

is measured TFP. The productivity cutoff z_is defined by

(14) λ(1 − Ω( _z , t)) = 1.

˙ ≡   s Y −   δ K,

capital αZKα−1 L1−α

It follows immediately that TFP Z(t) → max{z}αas t → ∞. Steady-state TFP and

ω(z) ≡  _  ∫    agt(a, z) da.

∫     e−ρ(s−t)  log [ws L] ds,

corr(log z(t), log z(t + s)) = e−(1/θ)s

(29) _1 (log z − m)2

where  V0is defined in (24).

∫     c˜ (z, t; γ, λ) ω(z, t) dz

Because in general the aggregate marginal propensity to consume ρ  (γ,

Π(a, z) = max{zπk − (r + δ)k s.t. k ≤ λa}.

ρv(z, t) = ρ log ρ − ρ + A(z, t) +  _  피 [dv(z, t)].

Y = ∫    ∫    y(a, z) g(a, z) da dz =  _ ∫

Substituting into (11), we see that Y = (λ XK)α L1−α

∂ω(z, t) ∂g(a, z, t)   ˙ (t)

(A9)  Vt = ( 1 − Θ ) ∫  V(a, z, t) dGt(a, z) + Θ ∫  e−ρ(s−t)

∂v(z, t) 1 ∂ v(z, t) 2