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Capital Structure Over The Business Cycle

Why are aggregate equity payouts and debt issued positively correlated over the business cycle in U.S. data? Standard real business cycle (RBC) models have few predictions about capital structure, because they assume that financial markets are frictionless. On the other hand, the tradeoff theory of capital structure argues that financial frictions determine firms' optimal mix of debt and equity financing. We develop an RBC model with financial frictions and use it to explain some stylized facts about aggregate U.S. debt and equity flows. We document that debt issued and equity payouts are (i) positively correlated with output, (ii) positively correlated with investment, and (iii) positively correlated with each other. Our model can account for these stylized facts. We also calibrate the model to the periods 1952 - 1983 and 1984 - 2007 in order to explain the finding that real variables have become less volatile in the later subperiod, while financial variables have become more volatile. By varying both the scale of technology shocks and the degree of financial frictions, we are able to account for both results.

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Paper provided by Georgetown University, Department of Economics in its series Working Papers with number gueconwpa~08-08-03.

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Date of creation: 03 Aug 2008
Date of revision:
Handle: RePEc:geo:guwopa:gueconwpa~08-08-03
Contact details of provider: Postal: Georgetown University Department of Economics Washington, DC 20057-1036
Phone: 202-687-6074
Fax: 202-687-6102
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Order Information: Postal: Roger Lagunoff Professor of Economics Georgetown University Department of Economics Washington, DC 20057-1036
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  1. Caballero, Ricardo J. & Farhi, Emmanuel & Gourinchas, Pierre-Olivier, 2008. "An Equilibrium Model of "Global Imbalances" and Low Interest Rates," Scholarly Articles 3229094, Harvard University Department of Economics.
  2. Bernanke, B. & Gertler, M. & Gilchrist, S., 1998. "The Financial Accelerator in a Quantitative Business Cycle Framework," Working Papers 98-03, C.V. Starr Center for Applied Economics, New York University.
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  9. Urban Jermann & Vincenzo Quadrini, 2007. "Financial Innovations and Macroeconomic Volatility," 2007 Meeting Papers 50, Society for Economic Dynamics.
  10. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
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  12. Hansen, Robert S & Torregrosa, Paul, 1992. " Underwriter Compensation and Corporate Monitoring," Journal of Finance, American Finance Association, vol. 47(4), pages 1537-55, September.
  13. James H. Scott Jr., 1976. "A Theory of Optimal Capital Structure," Bell Journal of Economics, The RAND Corporation, vol. 7(1), pages 33-54, Spring.
  14. Graham, John R. & Harvey, Campbell R., 2001. "The theory and practice of corporate finance: evidence from the field," Journal of Financial Economics, Elsevier, vol. 60(2-3), pages 187-243, May.
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