Business Cycle Effects of Credit Shocks in a DSGE Model with Firm Defaults

44 Pages Posted: 18 Apr 2016

See all articles by M. Hashem Pesaran

M. Hashem Pesaran

University of Southern California - Department of Economics; University of Cambridge - Trinity College (Cambridge)

TengTeng Xu

International Monetary Fund (IMF)

Date Written: April 1, 2016

Abstract

This paper proposes a new theoretical framework for the analysis of the relationship between credit shocks, firm defaults and volatility. The key feature of the modelling approach is to allow for the possibility of default in equilibrium. The model is then used to study the impact of credit shocks on business cycle dynamics. It is assumed that firms are identical ex ante but differ ex post due to different realizations of firm-specific technology shocks, possibly leading to default by some firms. The implications of firm defaults for the balance sheets of households and banks and their subsequent impacts on business fluctuations are investigated within a dynamic stochastic general equilibrium framework. Results from a calibrated version of the model suggests that, in the steady state, a firm's default probability rises with its leverage ratio and the level of uncertainty in the economy. A positive credit shock, defined as a rise in the loan-to-deposit ratio, increases output, consumption, hours and productivity, and reduces the spread between loan and deposit rates. Interestingly, the effects of the credit shock tend to be highly persistent, even without price rigidities and habit persistence in consumption behavior.

Keywords: Firm Defaults; Credit Shocks; Financial Intermediation; Interest Rate Spread; Uncertaintey

JEL Classification: E32, E44, E50, G21

Suggested Citation

Pesaran, M. Hashem and Xu, TengTeng, Business Cycle Effects of Credit Shocks in a DSGE Model with Firm Defaults (April 1, 2016). USC-INET Research Paper No. 16-13, Available at SSRN: https://ssrn.com/abstract=2764604 or http://dx.doi.org/10.2139/ssrn.2764604

M. Hashem Pesaran (Contact Author)

University of Southern California - Department of Economics

3620 South Vermont Ave. Kaprielian (KAP) Hall 300
Los Angeles, CA 90089
United States

University of Cambridge - Trinity College (Cambridge) ( email )

United Kingdom

TengTeng Xu

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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