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Credit Risk and Business Cycles

Jianjun Miao () and Pengfei Wang ()

No WP2010-033, Boston University - Department of Economics - Working Papers Series from Boston University - Department of Economics

Abstract: We incorporate long-term defaultable corporate bonds and credit risk in a dynamic stochastic general equilibrium business cycle model. Credit risk ampli¯es aggregate tech- nology shocks. The debt-capital ratio is a new state variable and its endogenous movements provide a propagation mechanism. The model can match the persistence and volatility of output growth as well as the mean equity premium and the mean risk-free rate as in the data. The model implied credit spreads are countercyclical and forecast future economic activities because they a®ect ¯rm investment through Tobin's Q. They also forecast future stock returns through changes in the market price of risk. Finally, we show that ¯nancial shocks to the credit markets are transmitted to the real economy through Tobin's Q.

Keywords: credit risk; credit spread; dynamic capital structure; equity premium; business cycles; investment; q-theory (search for similar items in EconPapers)
JEL-codes: E22 E32 G12 G32 G33 (search for similar items in EconPapers)
Pages: 48 pages
Date: 2010-01
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