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Default Risk and Aggregate Fluctuations in an Economy with Production Heterogeneity

  • Julia K. Thomas

    (Ohio State University)

  • Aubhik Khan

    (Ohio State University)

We study business cycle driven by exogenous changes in total factor productivity and credit shocks. The latter involve changes to the fraction of assets that lenders may seize in the event of default. Following changes in aggregate total factor productivity, we find that our non-contingent loan contracts drive countercyclical default risk. When firms face fixed costs of operation, this leads to a worsening of the allocation of capital in recessions that amplifies the effects of technology shocks. Following credit shocks, we see a reduction in economic activity that is qualitatively different from that following a technology shock. The response in investment is more serve, while the responses in consumption, employment and output are more gradual. In contrast to existing analysis of credit shocks with exogenous collateral constraints, our environment does not predict a slow recovery when borrowing conditions return to normal.

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Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 1333.

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Date of creation: 2011
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Handle: RePEc:red:sed011:1333
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

Web page: http://www.EconomicDynamics.org/
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  1. Arellano, Cristina, 2008. "Default risk and income fluctuations in emerging economies," MPRA Paper 7867, University Library of Munich, Germany.
  2. Jonathan Eaton & Mark Gersovitz, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Oxford University Press, vol. 48(2), pages 289-309.
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  4. Aguiar, Mark & Gopinath, Gita, 2006. "Defaultable debt, interest rates and the current account," Journal of International Economics, Elsevier, vol. 69(1), pages 64-83, June.
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  7. Diego Restuccia & Richard Rogerson, 2007. "Policy Distortions and Aggregate Productivity with Heterogeneous Plants," Working Papers tecipa-283, University of Toronto, Department of Economics.
  8. Aubhik Khan & Julia K. Thomas, 2004. "Idiosyncratic shocks and the role of nonconvexities in plant and aggregate investment dynamics," Working Papers 04-15, Federal Reserve Bank of Philadelphia.
  9. Per Krusell & Anthony A. Smith & Jr., 1998. "Income and Wealth Heterogeneity in the Macroeconomy," Journal of Political Economy, University of Chicago Press, vol. 106(5), pages 867-896, October.
  10. Gary Hansen, 2010. "Indivisible Labor and the Business Cycle," Levine's Working Paper Archive 233, David K. Levine.
  11. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
  12. Narayana R. Kocherlakota, 2000. "Creating business cycles through credit constraints," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Sum, pages 2-10.
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