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Default cycles

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  • Cui, Wei
  • Kaas, Leo

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

  • Cui, Wei & Kaas, Leo, 2017. "Default cycles," LSE Research Online Documents on Economics 86159, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:86159
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    More about this item

    Keywords

    Firm default; Financing constraints; Credit Spreads; Sunspots growth; population.;
    All these keywords.

    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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