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The Default Rate and Price of Capital in a Costly External Finance Model

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Juan Pablo Medina

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Abstract

Financial frictions have been used to enrich mechanism transmission in macroeconomics. However, the predictions of real business cycle models of costly external finance imply a procyclical default rate, external premium and relative price of capital which seems at odd with the data. In this article, we include technology shocks that affect the average productivity and idiosyncratic risk of capital producers in a standard costly external finance model. These elements enhance the model to deliver a countercyclical default rate, external finance and relative price of capital premium which is more consistent with the data and contrary to the result obtained with a sector neutral productivity shock. Intuitively, if the entrepreneurs' investment projects become more productive in average, the relative price of capital and the default rate fall while the investment and output increase. Using data on the relative price of capital, we perform a calibration of this type of shocks which highlights its business cycle relevance.

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Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 297.

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Date of creation: Dec 2004
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Handle: RePEc:chb:bcchwp:297

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