We develop a general equilibrium model that delivers realistic fluctuations in pay inequality as a result of changes in the technology frontier. In our model, executives add value to the firm not only by participating in production decisions, as do other workers in the economy, but also by identifying new investment opportunities. Improvements in technology that are specific to new vintages of capital raise the return to managers’ skills for discovering new growth projects and, thus, increase the compensation of executives relative to workers and disparities in pay across executives. Our model implies that, controlling for firm size, compensation is higher in fast-growing firms and that pay inequality increases as investment opportunities in the economy improve. Both predictions are consistent with the data.

We provide new evidence that a disruption in credit supply played a quantitatively significant role in the unprecedented contraction of employment during the Great Depression using a novel, hand-collected dataset of large industrial firms. Our identification strategy exploits preexisting variation in the need to raise external funds at a time when public bond markets essentially froze. Local bank failures inhibited firms’ ability to substitute public debt for private debt, which exacerbated financial constraints. We estimate a large and negative causal effect of financing frictions on firm employment. We find that the lack of access to credit likely accounted for a substantial fraction of the aggregate decline in employment of large firms between 1928 and 1933.

We embed adverse selection into a dynamic, general equilibrium model with heterogeneous capital and study its implications for aggregate dynamics. The friction leads to delays in firms’ divestment decisions and thus slow recoveries from shocks, even when these shocks do not affect the economy’s potential output. The impediments to reallocation increase with the dispersion in productivity and decrease with the interest rate, the frequency of sectoral shocks, and households’ consumption smoothing motives. When households are risk averse, delaying reallocation serves as a hedge against future shocks, which can lead to persistent misallocation. Our model also provides a micro-foundation for convex adjustment costs and a link between the nature of these costs and the underlying economic environment.