Corporate Leverage and Financial Fragility in General Equilibrium

Andrew Levin () and Fabio M. Natalucci

No 182, Computing in Economics and Finance 2005 from Society for Computational Economics

Abstract: We provide analytical and empirical underpinnings for the notion that the financial fragility of the aggregate economy depends on the balance sheet conditions of the corporate sector. First, we obtain time-varying semiparametric estimates of the relationship between the debt-equity ratio and the credit spread on publicly-traded bonds using a newly-constructed firm-level dataset. The estimated leverage-spread schedule exhibits statistically significant nonlinearity that is consistent with the theoretical predictions of a canonical debt-contracting problem with asymmetric information. We then proceed to analyze the aggregate implications of this nonlinearity by obtaining a second-order approximation of a dynamic general equilibrium model with financial market frictions. Finally, using this framework, we quantify the degree of financial fragility of the U.S. economy during the high-leverage period of the late 1980s compared with the low-leverage period of the late 1990s

Keywords: financial market frictions; nonlinearities (search for similar items in EconPapers)
JEL-codes: D82 E22 G32 (search for similar items in EconPapers)
Date: 2005-11-11
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Citations: View citations in EconPapers (3)

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Persistent link: https://EconPapers.repec.org/RePEc:sce:scecf5:182

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