Flexibility and Frictions in Multisector Models

Cross-sectoral heterogeneity in sectoral bond spreads is related to sectoral elasticities of substitution in production. During the Great Recession, more flexible firms paid lower sectoral bond spreads, generated higher revenues, and held more working capital. A model consistent with these facts— input-output linkages, working capital constraints, and heterogeneous elasticities—predicts that sectoral distortions during the Great Recession generated an efficiency wedge—due to input misallocation—2.4 times larger than one with homogeneous production functions. In addition, our model predicts input-output connections amplified the Great Recession 2.3 times as much as one with homogeneous elasticities.