Debt, Default and Business Cycles with Heterogeneous Firms

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This award funds research on the effects of financial shocks on macroeconomic activity. In the 2007 recession, financial shocks to the credit market were followed by a sharp decline in aggregate investment and employment. However, the credit shocks did not affect all firms in the same way. For example, we know that job loss was disproportionately concentrated among small firms compared to past recessions, and firms with lower cash holdings experienced far larger declines in investment spending. The PIs will develop new quantitative models of how financial shocks affect the economy through effects on different kinds of individual firms. Existing models largely rely on an assumption that all firms in a sector are very similar. The new model is more difficult to analyze, but also more realistic. The model and methods developed in this project may improve our ability to determine whether or not a given financial shock will result in recession.The PIs will develop and solve two quantitative DSGE models wherein shocks to financial markets affect borrowers' default risk and thus credit conditions facing nonfinancial firms. The models include a distribution of firms over capital, debt and firm specific productivity, endogenous firm entry and exit, financial shocks affecting equilibrium loan rate schedules offered to borrowers, and real shocks affecting aggregate productivity. The first model explores one-period debt; the second generalizes the first to accommodate firms with differing debt maturities. Firms accumulate capital and may borrow or save; for consistency with firm-level financial data, the model allows for retained earnings. The PIs target the observed relation between size and leverage and the volatility of cash ratios among U.S. nonfinancial firms in the model calibration.