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Monetary Policy and Corporate Default

39 Pages Posted: 2 Feb 2011 Last revised: 7 May 2013

Harjoat Singh Bhamra

Imperial College Business School

Adlai J. Fisher

University of British Columbia (UBC) - Sauder School of Business

Lars-Alexander Kuehn

Carnegie Mellon University - David A. Tepper School of Business

Date Written: July 1, 2011

Abstract

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

Suggested Citation

Bhamra, Harjoat Singh and Fisher, Adlai J. and Kuehn, Lars-Alexander, Monetary Policy and Corporate Default (July 1, 2011). Journal of Monetary Economics, 58 (5), 480-494, July 2011. Available at SSRN: https://ssrn.com/abstract=1750347

Harjoat Singh Bhamra (Contact Author)

Imperial College Business School ( email )

Tanaka Building
Exhibition Rd
London, SW7 2AZ
United Kingdom

HOME PAGE: http://www.harjoatbhamra.com

Adlai J. Fisher

University of British Columbia (UBC) - Sauder School of Business ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada
604-822-8331 (Phone)
604-822-4695 (Fax)

HOME PAGE: http://finance.sauder.ubc.ca/~fisher

Lars-Alexander Kuehn

Carnegie Mellon University - David A. Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States

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