Price Rigidities and Credit Risk

Abstract

We develop a capital structure model in which firms have a differential flexibility in adjusting
output prices to shocks. Inflexible-price firms have lower profits and higher cash-flow
volatility, leading in equilibrium to lower financial leverage, shorter debt duration, higher
cost of debt, more stringent debt covenants, and higher precautionary cash holdings. Shocks
to cash-flow volatility increase the cost of debt more for inflexible-price firms. We confirm
these predictions empirically and document that inflexible-price firms experience a significantly
larger increase in credit spreads in response to monetary policy shocks and to the
2008 Lehman Brothers bankruptcy, especially when they face higher pre-shock rollover risk.

Keywords: sticky prices, monetary policy, credit risk, nominal rigidities

JEL Classification: E12, E44, E52, G12, G28, G32, G33