Financial Heterogeneity and the Investment Channel of Monetary Policy

Motivated by the observation that aggregate investment is one of the most cyclically responsive components of GDP, this paper asks which firms drive that response: those most affected by financial frictions, or those least affected? Combining a high-frequency-identified measure of monetary policy shocks with quarterly Compustat data, the paper finds that firms with lower default risk – measured by lower leverage and a higher structural “distance to default” – invest significantly more in response to an expansionary monetary shock than high-default-risk firms, with a one-standard-deviation lower leverage ratio associated with roughly a one-quarter larger investment semielasticity and a one-standard-deviation higher distance to default with roughly a one-half larger one; these differential responses persist for up to three years and are accompanied by low-risk firms gaining relatively more access to external finance and facing smaller increases in borrowing costs than high-risk firms after an expansionary shock. To interpret this finding, the paper embeds heterogeneous firms subject to collateralized borrowing and endogenous default risk into an otherwise standard New Keynesian model with sticky-price retailers, calibrated to match firm-level investment, borrowing, and lifecycle facts, and reproduces the empirical pattern: low-risk firms are more responsive because they face a comparatively flat marginal cost-of-investment-finance curve, so the direct effect of a lower real interest rate on the marginal benefit of capital passes through to investment largely undamped, whereas high-risk (net-worth-constrained) firms sit on the upward-sloping segment of that curve, where a monetary expansion’s cash-flow, collateral-value, and default-probability channels only partially offset the higher financing cost of additional capital. The paper’s decomposition further shows that, unlike in household-consumption models (Kaplan, Moll and Violante 2018; Auclert 2019), where indirect general-equilibrium income effects dominate the direct interest-rate effect, both direct and indirect price effects contribute quantitatively to firm investment responses, because firms are more interest-sensitive than consumption-smoothing households. Because low-risk firms drive most of the aggregate response, the model implies the aggregate potency of monetary policy depends on the prevailing cross-sectional distribution of default risk: a counterfactual low-net-worth initial distribution generates an aggregate capital response about 33% smaller than the calibrated steady-state distribution, even though every constrained firm remains more responsive to monetary policy than it would be absent financial frictions altogether – consistent with the amplification logic of Bernanke, Gertler and Gilchrist (1999).

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Financial Heterogeneity and the Investment Channel of Monetary Policy