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Default Cycles

Leo Kaas and Wei Cui
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Wei Cui: University College London

No 1288, 2017 Meeting Papers from Society for Economic Dynamics

Abstract: Corporate default rates are counter-cyclical and are often accompanied by declines of business credit over prolonged episodes. This paper develops a tractable macroeconomic model in which persistent credit and default cycles are the outcome of variations in self-fulfilling beliefs about credit market conditions. Interest spreads and leverage ratios are determined in optimal credit contracts that reflect the expected default risk of borrowing firms. Next to sunspot shocks, the model also features shocks to recovery rates and to financial intermediation costs. We calibrate the model to evaluate the impact of these different financial shocks on the credit market and on output dynamics. Self-fulfilling changes in credit market expectations trigger sizable reactions in default rates and generate endogenously persistent credit and output cycles. All credit market shocks together account for over 50% of the variation of U.S. GDP growth during 1982-2015.

Date: 2017
New Economics Papers: this item is included in nep-dge, nep-mac and nep-rmg
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