Debt Overhang in a Business Cycle Model

42 Pages Posted: 24 Apr 2010 Last revised: 15 Dec 2010

See all articles by Filippo Occhino

Filippo Occhino

Federal Reserve Banks - Federal Reserve Bank of Cleveland

Andrea Pescatori

Federal Reserve Bank of Cleveland

Date Written: December 9, 2010

Abstract

We study the macroeconomic implications of the debt overhang distortion. In our model, the distortion arises because investment is noncontractible - 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.

Keywords: Debt Overhang, Default, Credit Risk, Financial Frictions, Financial-Accelerator

JEL Classification: E32, E44

Suggested Citation

Occhino, Filippo and Pescatori, Andrea, Debt Overhang in a Business Cycle Model (December 9, 2010). FRB of Cleveland Working Paper No. 10-03R. Available at SSRN: https://ssrn.com/abstract=1595077 or http://dx.doi.org/10.2139/ssrn.1595077

Filippo Occhino (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Cleveland ( email )

East 6th & Superior
Cleveland, OH 44101-1387
United States

Andrea Pescatori

Federal Reserve Bank of Cleveland ( email )

1455 E 6th ST
Cleveland, OH 44114
United States

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