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Debt overhang in a business cycle model

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  • Occhino, Filippo
  • Pescatori, Andrea

Abstract

We study the macroeconomic implications of the debt overhang distortion on firms׳ investment and labor decisions. We show that the distortion arises when the levels of investment and labor are non-contractible and chosen after the signing of the debt contract. The financial friction manifests itself as investment and labor wedges that move counter-cyclically, increasing during recessions when the risk of default is high. Their dynamics amplify and propagate the effects of shocks to productivity, government spending, volatility, and funding costs. Both the size and the persistence of these effects are quantitatively important.

Suggested Citation

  • Occhino, Filippo & Pescatori, Andrea, 2015. "Debt overhang in a business cycle model," European Economic Review, Elsevier, vol. 73(C), pages 58-84.
    • Handle: RePEc:eee:eecrev:v:73:y:2015:i:c:p:58-84
    DOI: 10.1016/j.euroecorev.2014.11.003
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    3. Halling, Michael & Yu, Jin & Zechner, Josef, 2016. "Leverage dynamics over the business cycle," Journal of Financial Economics, Elsevier, vol. 122(1), pages 21-41.
    4. Sweder J.G. van Wijnbergen & Egle Jakucionyte, 2017. "Debt Overhang, Exchange Rates and the Macroeconomics of Carry Trade," Tinbergen Institute Discussion Papers 17-005/VI, Tinbergen Institute, revised 15 Jun 2018.
    5. João Gomes & Urban Jermann & Lukas Schmid, 2016. "Sticky Leverage," American Economic Review, American Economic Association, vol. 106(12), pages 3800-3828, December.
    6. Occhino Filippo & Pescatori Andrea, 2014. "Leverage, investment, and optimal monetary policy," The B.E. Journal of Macroeconomics, De Gruyter, vol. 14(1), pages 1-21, January.
    7. Yang, Bo & Gan, Liu & Wen, Chunhui, 2021. "Moral hazard, debt overhang and capital structure," The North American Journal of Economics and Finance, Elsevier, vol. 58(C).
    8. Jakucionyte, Egle & van Wijnbergen, Sweder, 2018. "Unclogging the Credit Channel: on the Macroeconomics of Banking frictions," CEPR Discussion Papers 12729, C.E.P.R. Discussion Papers.
    9. Giordano, Claire & Marinucci, Marco & Silvestrini, Andrea, 2019. "The macro determinants of firms' and households' investment: Evidence from Italy," Economic Modelling, Elsevier, vol. 78(C), pages 118-133.
    10. Joachim Jungherr & Immo Schott, 2022. "Slow Debt, Deep Recessions," American Economic Journal: Macroeconomics, American Economic Association, vol. 14(1), pages 224-259, January.
    11. Auer, Simone & Bernardini, Marco & Cecioni, Martina, 2021. "Corporate leverage and monetary policy effectiveness in the euro area," European Economic Review, Elsevier, vol. 140(C).
    12. Emilios Avgouleas, 2015. "Bank Leverage Ratios and Financial Stability: A Micro- and Macroprudential Perspective," Economics Working Paper Archive wp_849, Levy Economics Institute.
    13. Sebastian Di Tella & Robert E. Hall, 2020. "Risk Premium Shocks Can Create Inefficient Recessions," NBER Working Papers 26721, National Bureau of Economic Research, Inc.
    14. Eduardo Borensztein & Lei Sandy Ye, 2021. "Corporate debt overhang and investment in emerging economies: Firm‐level evidence," International Finance, Wiley Blackwell, vol. 24(1), pages 18-39, April.
    15. Occhino, Filippo, 2017. "The 2012 eurozone crisis and the ECB’s OMT program: A debt-overhang banking and sovereign crisis interpretation," European Economic Review, Elsevier, vol. 100(C), pages 337-363.
    16. Cheng-wei Chang & Ching-chong Lai & Ting-wei Lai, 2020. "Fiscal stimulus in a simple macroeconomic model of monopolistic competition with firm heterogeneity," The Japanese Economic Review, Springer, vol. 71(3), pages 447-477, July.
    17. Joachim Jungherr & Immo Schott, 2018. "The Long-term Debt Accelerator," 2018 Meeting Papers 961, Society for Economic Dynamics.
    18. Jakucionyte, Egle & van Wijnbergen, Sweder, 2017. "Debt Overhang and the Macroeconomics of Carry Trade," CEPR Discussion Papers 11788, C.E.P.R. Discussion Papers.
    19. James Bullard & Jacek Suda & Aarti Singh & Costas Azariadis, 2014. "Debt Overhang and Monetary Policy," 2014 Meeting Papers 948, Society for Economic Dynamics.
    20. Hiebert, Paul & Jaccard, Ivan & Schüler, Yves, 2018. "Contrasting financial and business cycles: Stylized facts and candidate explanations," Journal of Financial Stability, Elsevier, vol. 38(C), pages 72-80.
    21. Filippo Occhino, 2014. "Debt-Overhang Banking Crises," Working Papers (Old Series) 1425, Federal Reserve Bank of Cleveland.
    22. Joseph Brian Cumbie & John Donnellan, 2017. "The Impact of Working Capital Components on Firm Value in US Firms," International Journal of Economics and Finance, Canadian Center of Science and Education, vol. 9(8), pages 138-150, August.
    23. repec:ajk:ajkpbs:024 is not listed on IDEAS
    24. Filippo Occhino, 2015. "The 2012 Eurozone Crisis and the ECB’s OMT Program: A Debt-Overhang Banking and Sovereign Crisis Interpretation The 2012 Eurozone Crisis and the ECB’s OMT Program: A Debt-Overhang Banking and Sovereig," Working Papers (Old Series) 1509, Federal Reserve Bank of Cleveland.
    25. Occhino, Filippo, 2017. "Debt-overhang banking crises: Detecting and preventing systemic risk," Journal of Financial Stability, Elsevier, vol. 30(C), pages 192-208.

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    More about this item

    Keywords

    Financial frictions; Financial accelerator; Optimal financial contract; Investment wedge; Labor wedge;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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