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Debt overhang and credit risk in a business cycle model

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  • Filippo Occhino
  • Andrea Pescatori

Abstract

We study the macroeconomic implications of the debt overhang distortion. In our model, the distortion arises because investment is non-contractible—when a firm borrows funds, the debt contract cannot specify or depend on the firm’s future level of investment. After the debt contract is signed, the probability that the firm will default on its debt obligation acts like a tax that discourages its new investment, because the marginal benefit of that investment will be reaped by the creditors in the event of default. We show that the distortion moves countercyclically: It increases during recessions, when the risk of default is high. Its 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. The model replicates important features of the joint dynamics of macro variables and credit risk variables, like default rates, recovery rates and credit spreads.

Suggested Citation

  • Filippo Occhino & Andrea Pescatori, 2010. "Debt overhang and credit risk in a business cycle model," Working Paper 1003, Federal Reserve Bank of Cleveland.
  • Handle: RePEc:fip:fedcwp:1003
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    Cited by:

    1. Kose,Ayhan & Ohnsorge,Franziska Lieselotte & Ye,Lei Sandy & Islamaj,Ergys, 2017. "Weakness in investment growth : causes, implications and policy responses," Policy Research Working Paper Series 7990, The World Bank.
    2. van der Kwaak, C.G.F. & van Wijnbergen, S.J.G., 2014. "Financial fragility, sovereign default risk and the limits to commercial bank bail-outs," Journal of Economic Dynamics and Control, Elsevier, vol. 43(C), pages 218-240.
    3. World Bank Group, 2017. "Global Economic Prospects, January 2017," World Bank Publications, The World Bank, number 25823, July.

    More about this item

    Keywords

    Corporations - Finance ; Debt ; Business cycles ; Risk;

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