Default Cycles

This seminar is part of the Department of Economics Seminar Series 2016-17. The seminars are open to all - no registration necessary.

Abstract

Corporate default rates are counter-cyclical and are often clustered over prolonged episodes. This paper develops a tractable macroeconomic model in which persistent default cycles are the outcome of variations in self-fulfilling beliefs about credit market conditions. Interest spreads and leverage ratios are determined in optimal debt contracts that reflect the expected default risk of borrowing firms. Next to sunspot shocks, the model also features other financial shocks that are unrelated to default risk. We calibrate the model to evaluate the impact of the different financial shocks on the credit market and on output dynamics. Self-fulfilling credit market expectations trigger sizeable reactions in default rates and generate endogenously persistent credit and output cycles. All credit market shocks together account for over 80% of the variance of U.S. GDP growth during 1982-2015.