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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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