Firm Dynamics after COVID-19: A Structural Model

Guzman Gonzalez-Torres (Banca d'Italia)

Abstract

Abstract I study the effects of the COVID-19 pandemic on firm dynamics and the real economy, and evaluate the efficacy of various policies designed to lower firms' liquidity needs. I propose a firm dynamics model with investment in physical capital, in which firms seek out external liquidity in order to finance ongoing operations. In response to an unexpected fall in aggregate demand as well as temporary workforce reductions due to stay at home orders, firm exit increases and entry decreases. The pandemic has lasting effects on the stock of firms and aggregate output, but only transitory effects on firm selection and aggregate growth. I find that policies which directly reduce fixed costs can have a significant effect on the evolution of the real economy in the long run by curbing firm exit in the immediate aftermath of an aggregate shock. However, the policies need to be in place several periods in the worst hit sectors of the economy in order to be effective because firms expect aggregate demand to only recover slowly. Measures attempting to lower firm total payrolls on the other hand are only effective in sectors heavily affected by stay at home orders.

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