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A Forest Fire Theory of the Duration of a Boom and the Size of a Subsequent Bust

Abstract

We show that, in a large class of models, market frictions lead to predictable dynamic patterns of the acquisition and subsequent shedding of inputs by firms. The logic is as follows. During high demand and expansionary periods, firms that fail to have inputs (machinery, labor, space, credit) in place forego potentially large profit opportunities. Frictions in searching for inputs thus lead firms to accept sub-optimal inputs to take advantage of current profit opportunities. The longer an expansionary period lasts, the greater the buildup in both the absolute and relative amount of low-productivity inputs. Once an economic downturn eventually hits, firms shed low-productivity inputs and so the longer the expansion has lasted, the larger the absolute and percentage drop in the employment of a wide variety of inputs. To motivate our model, we document that such patterns are quite strong in US data, both in terms of employment and rental contracts. For instance, we find that five additional years of expansion lead to an additional drop of thirty percent in employment growth at the onset of a downturn.

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