Equilibrium Investment and Asset Prices under Imperfect Corporate Control

Equilibrium Investment and Asset Prices under Imperfect Corporate Control

By
James Dow, Gary Gorton, Arvind Krishnamurthy
American Economic Review. June
2005, Vol. 95, Issue 3, Pages 659-681

We integrate a widely accepted version of the separation of ownership and control—Michael Jensen’s (1986) free cash flow theory—into a dynamic equilibrium model, and study the effect of imperfect corporate control on asset prices and investment. Aggregate free cash flow of the corporate sector is an important state variable in explaining asset prices, investment, and the cyclical behavior of interest rates and the yield curve. The financial friction causes cash-flow shocks to affect investment, and causes otherwise i.i.d. shocks to be transmitted from period to period. The shocks propagate through large firms and during booms.