Capital, Ideas, and the Costs of Financial Frictions

Title: Capital, Ideas, and the Costs of Financial Frictions

Abstract: We study the role of financial frictions in determining the allocation of investment

and innovation. Empirically, we find that established firms are investment-intensive

when they have low net worth but become innovation-intensive as they accumulate

net worth. To interpret these findings, we develop an endogenous growth model with

heterogeneous firms and financial frictions. In our model, firms are investment-intensive

when they have low net worth because their returns to capital are high. Financial

frictions determine the rate at which firms drive down the returns to capital and shift

towards innovation. Quantitatively, the aggregate losses due to lower innovation are

large, even though the allocation of capital to existing ideas is comparatively efficient. If

innovation has positive spillovers, a planner would lower investment among constrained

firms to finance more innovation. An innovation subsidy does not generate the correct

distribution of investment and innovation to exactly decentralize this outcome.