How do firms adjust their balance sheets and reallocate capital stock in response to recurrent productivity or profitability shocks? Why does capital reallocation fluctuate procyclically, while the potential benefits to reallocate appear to be countercyclical? To answer these questions, this paper develops a tractable dynamic general equilibrium model. In the model, firms face idiosyncratic productivity shocks while at the same time are restricted by the illiquidity of capital stock and financing constraints. The model shows that asset illiquidity and financing constraints interact and generate capital reallocation delays. These delays result in cross-sectional productivity dispersion and losses of total factor productivity (TFP), which become more severe during recessions.

Should monetary policy react to asset price levels and changes in the context of financing frictions? To answer the question, we provide a tractable monetary Ramsey approach for a heterogeneous-agents model with conventional policy (interest rate or money growth target) and unconventional policy (purchase of private illiquid assets) as instruments, in which interactions of heterogeneous agents are summarized in one implementability condition. We show that entrepreneurs hold too much liquid asset in the economy with equity issuance and resale (liquidity) constraints. In the steady state, optimal policy targets paying interest on liquid assets, leading to an equivalent increase of 0.4% in permanent consumption compared to the economy under no policy. In responding to adverse liquidity shocks, macroeconomic dynamics under no policy and optimal policy are sharply different and suggest the need for buying illiquid assets and raising interest rates, instead of usual response of reducing interest rates. Finally, we prove that the unconventional policy dominates the conventional counterpart, but the welfare difference is quantitatively negligible.

One major question in micro lending is whether joint liability is the key for success. In the literature, joint liability is more effective in overcoming adverse selection through endogenous peer selection, or in preventing moral hazard through peer monitoring. I construct a model combining the two and show that joint liability may not be successful. In the model, I show that joint liability still leads to peer selection even if moral hazard is introduced. Then risk-homogeneous groups are formed and they are also return-homogeneous groups. However, homogeneous groups are more likely to have strategic default from moral hazard than heterogeneous groups due to different official penalties on default. Then, the break-even bank may no longer offer an interest rate that is low enough to attract safe borrowers; or joint liability may be socially inefficient since the bank may set a very low interest rate together with a very high joint liability which hurts risky borrowers more. Therefore, joint liability is unlikely to overcome adverse selection and moral hazard together.