Firm entry and exit, investment irreversibility, and business cycle dynamics

This paper studies the role of firms' entry and exit for business cycle dynamics in an environment, where physical capital is partially sunk. Extending a heterogeneous-firm model a la Hopenhayn (1992) by aggregate productivity shocks and partially irreversible investment yields substantial endogenous amplification and propagation. A positive aggregate productivity shock increases the number of entrants and their initial investment levels, because the expected entry value outweighs the implicit sunk cost associated with investment irreversibility. The endogenous propagation of an exogenous stimulus arises via a built-in selection device, as the production growth of new businesses over their life cycle exceeds the decay due to exits of the least productive firms.