Price Rigidities and Credit Risk
80 Pages Posted: 25 May 2021 Last revised: 21 Jun 2023
Date Written: June 20, 2023
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
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