Endogenous fluctutations: a financial transmission Mechanism

Abstract

We propose to study the dynamic impact of adjustment costs in capital on the two sectors model with positive sector specific externalities. We proove that such costs are able to lead to endogenous fluctuations by financial transmission mechanism. Indeed, since adjustments costs are linked to the marginal Q of Tobin, the firm's investment decision depends on the gap between the true value of the assets of this firm and their market value. The marginal Q of Tobin is an indicator of this market value and when adjustment costs are sufficiently high they can interplay with sector-specific externalities to provide endogenous fluctuations. We can prove fluctuations and cycle arise for new configurations of capital intensity across sectors. Classically, in this model, these fluctuations take place with sufficiently high level of sector-specific externalities but only with capital intensity reversal across sector. When adjustment costs are considered, reversal is no longer necessary condition to endogenous fluctuations to arise. Moreover, we show that there exists a link between financial volatility, mesured by variations of the marginal Q of Tobin, and fluctuations