Monetary Policy and Firm Heterogeneity: The Role of Leverage Since the Financial Crisis

Abstract

We show that the role of leverage in explaining firm-level responses to monetary policy changed around the financial crisis of 2007-09. Stock prices of firms with high leverage were less responsive to monetary policy shocks in the pre-crisis period but have become more responsive since the crisis. Using expected volatility measures from firm-level options, we further document that financial markets have been aware of this change. To explain this, we consider a model where firms borrow using both short-term and long-term debt. The reversal relies on the relative strength of two competing channels of monetary transmission through the existing level of debt: debt dilution and debt overhang.  Before the crisis, the debt overhang channel dominated, so firms with high leverage were less responsive. Since the crisis, unconventional monetary policy has had an outsized effect on long-term interest rates, strengthening the debt dilution channel that benefits firms with high leverage more. Additional firm-level evidence supports this mechanism.

Keywords: monetary policy transmission, leverage, firm heterogeneity, debt maturity

JEL Classification: E52, E44, E43, E22