To understand the link between financial intermediation activities and the real economy, we put forward a general equilibrium model where agency frictions in the financial sector affect the efficiency of capital reallocation across firms and generate aggregate economic fluctuations. We develop a recursive policy iteration approach to fully characterize the nonlinear equilibrium dynamics and the off-steady state crisis behavior. In our model, adverse shocks to agency frictions exacerbate capital misallocation and manifest themselves as variations in total factor productivity at the aggregate level. Our model endogenously generates counter-cyclical volatility in aggregate time series and counter-cyclical dispersion of marginal product of capital and asset returns in the cross-section.

Hengjie Ai is an Assistant Professor of Finance at Carlson School of Management, University of Minnesota. Professor Ai received a B.A. in World Economy from Wuhan University in 1993, and a M.A. and a Ph.D. in Economics from Renmin University of China and University of Minnesota respectively. Prior to joining the Carlson School of Management, he was an Assistant Professor of Finance at the Fuqua School of Business, Duke University (2006-2012). His papers have appeared in Journal of Finance, Review of Financial Studies, Journal of Financial Economics and other leading finance journals. His research and teaching interests are mainly in financial economics, macroeconomics and economic theory.