Credit Market Frictions and the Linkage Between Micro and Macro Uncertainty

Abstract

This paper proposes a quantitative general equilibrium model with credit market frictions to explain the observed stylized facts of micro uncertainty (dispersion of re- alized firm-level outcomes) and macro uncertainty (volatility of aggregate economic variables). They are conceptually different but strongly comove and countercyclical. In my model economy, an increase in the dispersion of firm-level idiosyncratic shocks leads to more firms in the left tail of the distribution to default, which reduces the total net worth of the corporate sector. As a result, leverage increases, it magnifies the shock amplification mechanism of credit market frictions. Hence, the economy becomes more sensitive to aggregate shocks when micro uncertainty is high and the aggregate economy is more volatile. Consistent with the model predictions, I find that in the data, micro uncertainty, based on the dispersion of firm-level stock returns and sales growth, positively predicts future credit spreads.

Keywords: Uncertainty, Volatility, Financial Frictions, Macroeconomics, Asset Pricing

JEL Classification: D8, E3, G12