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Credit Risk and Business Cycles

  • Jianjun Miao

    ()

    (Department of Economics, Boston University, CEMA, Central University of Finance and Economics, and AFR, Zhejiang University)

  • PENGFEI WANG

    ()

    (Department of Economics, Hong Kong University of Science and Technology, ClearWater Bay, Hong Kong.)

We incorporate long-term defaultable corporate bonds and credit risk in a dynamic stochastic general equilibrium business cycle model. Credit risk ampli¯es aggregate tech- nology shocks. The debt-capital ratio is a new state variable and its endogenous movements provide a propagation mechanism. The model can match the persistence and volatility of output growth as well as the mean equity premium and the mean risk-free rate as in the data. The model implied credit spreads are countercyclical and forecast future economic activities because they a®ect ¯rm investment through Tobin's Q. They also forecast future stock returns through changes in the market price of risk. Finally, we show that ¯nancial shocks to the credit markets are transmitted to the real economy through Tobin's Q.

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Paper provided by Boston University - Department of Economics in its series Boston University - Department of Economics - Working Papers Series with number WP2010-033.

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Length: 48 pages
Date of creation: Jan 2010
Date of revision:
Handle: RePEc:bos:wpaper:wp2010-032
Contact details of provider: Postal: 270 Bay State Road, Boston, MA 02215
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Web page: http://www.bu.edu/econ/
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