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Default Cycles

Author

Listed:
  • Wei Cui

    () (Centre for Macroeconomics (CFM)
    University College London (UCL))

  • Leo Kaas

    () (University of Konstanz)

Abstract

Recessions are often accompanied by spikes of corporate default and prolonged declines of business credit. This paper argues that credit and default cycles are the outcomes of variations in self-fulfilling beliefs about credit market conditions. We develop a tractable macroeconomic model in which leverage ratios and interest spreads are determined in optimal credit contracts that reflect the expected default risk of borrowing firms. We calibrate the model to evaluate the impact of sunspots and fundamental shocks on the credit market and on output dynamics. Self-fulfilling changes in credit market expectations trigger sizable reactions in default rates and generate endogenously persistent credit and output cycles. All credit market shocks together account for about 50% of the variation of U.S. output growth during 1982-2015.

Suggested Citation

  • Wei Cui & Leo Kaas, 2017. "Default Cycles," Discussion Papers 1716, Centre for Macroeconomics (CFM).
  • Handle: RePEc:cfm:wpaper:1716
    as

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    File URL: http://www.centreformacroeconomics.ac.uk/Discussion-Papers/2017/CFMDP2017-16-Paper.pdf
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    References listed on IDEAS

    as
    1. Karel Mertens & Morten Overgaard Ravn, 2011. "Understanding the Aggregate Effects of Anticipated and Unanticipated Tax Policy Shocks," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 14(1), pages 27-54, January.
    2. repec:spr:joecth:v:64:y:2017:i:4:d:10.1007_s00199-017-1085-5 is not listed on IDEAS
    3. Chao Gu & Fabrizio Mattesini & Cyril Monnet & Randall Wright, 2013. "Endogenous Credit Cycles," Journal of Political Economy, University of Chicago Press, vol. 121(5), pages 940-965.
    4. Harold L. Cole & Timothy J. Kehoe, 2000. "Self-Fulfilling Debt Crises," Review of Economic Studies, Oxford University Press, vol. 67(1), pages 91-116.
    5. Karel Mertens & Morten Overgaard Ravn, 2011. "Understanding the Aggregate Effects of Anticipated and Unanticipated Tax Policy Shocks," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 14(1), pages 27-54, January.
    6. Sergei A. Davydenko & Ilya A. Strebulaev & Xiaofei Zhao, 2012. "A Market-Based Study of the Cost of Default," Review of Financial Studies, Society for Financial Studies, vol. 25(10), pages 2959-2999.
    7. Juan Carlos Conesa & Timothy J. Kehoe, 2017. "Gambling for redemption and self-fulfilling debt crises," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 64(4), pages 707-740, December.
    8. repec:oup:rasset:v:2:y:2012:i:2:p:153-202. is not listed on IDEAS
    9. Michael Keane & Richard Rogerson, 2012. "Micro and Macro Labor Supply Elasticities: A Reassessment of Conventional Wisdom," Journal of Economic Literature, American Economic Association, vol. 50(2), pages 464-476, June.
    10. Gertler, Mark & Karadi, Peter, 2011. "A model of unconventional monetary policy," Journal of Monetary Economics, Elsevier, vol. 58(1), pages 17-34, January.
    11. Tatsuro Senga & Julia Thomas & Aubhik Khan, 2017. "Default Risk and Aggregate Fluctuations in an Economy with Production Heterogeneity," 2017 Meeting Papers 889, Society for Economic Dynamics.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Firm default; Financing constraints; Credit spreads; Sunspots;

    JEL classification:

    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • 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
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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