Monetary Policy and Corporate Default
39 Pages Posted: 2 Feb 2011 Last revised: 7 May 2013
Date Written: July 1, 2011
When a corporation issues debt with a fixed nominal coupon, the real value of future payments decreases with the price level. Forward-looking corporate default decisions therefore depend on monetary policy through its impact on expected inflation. We build a general equilibrium economy with deadweight bankruptcy costs that demonstrates how nominal rigidities in corporate debt create an important role for monetary policy even in the absence of standard nominal frictions such as staggered price setting in the output market. Under a passive nominal interest rate peg, the direct effects of a negative pro- ductivity shock combine with deflation to produce strong incentives for corporate default. A debt-deflationary spiral results when there are real costs of financial distress. Inflation targeting eliminates this amplification mechanism but full inflation targeting requires permitting the nominal interest rate to depend explicitly on credit market conditions.
Keywords: Monetary policy, interest rate rule, corporate default, capital structure, leverage, credit spreads
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