Economic Uncertainty, Aggregate Debt, and the Real Effects of Corporate Finance
77 Pages Posted: 26 Oct 2016 Last revised: 26 Oct 2018
Date Written: October 23, 2018
This paper develops a tractable general equilibrium with endogenous firm capital structure decisions driven by changes in economic uncertainty. The model enables a critical assessment of standard paradigms of corporate finance in order to highlight empirically important directions for improvement, and help understand potential real effects. The standard trade-off version of the model implies that debt incentives contract with risk. Yet, surprisingly, aggregate and firm-level evidence shows that leverage -- and debt levels -- increase with uncertainty. This effect is not due to precautionary cash hoarding, binding restructuring constraints, or capital supply frictions. The analysis thus points towards alternative formulations in which debt incentives increase with risk. A version of the model with moral hazard via default insurance can account for the joint dynamics of uncertainty, credit spreads and debt. In this version, unlike the trade-off case, the real effects of debt can become severely negative.
Keywords: Debt Dynamics, Uncertainty Shocks, Credit Spreads, Real Effects of Finance
JEL Classification: E21, E32, G12, G32
Suggested Citation: Suggested Citation