The Persistence of Investment Inefficiencies: The Dynamics of Default and Endogenous Leverage

48 Pages Posted: 25 Oct 2021

See all articles by Theofanis Papamichalis

Theofanis Papamichalis

University of Cambridge

Dimitrios P. Tsomocos

University of Oxford - Said Business School and St. Edmund Hall

Nikolaos Romanidis

University of Oxford - Said Business School

Date Written: October 24, 2021

Abstract

We propose a tractable framework that incorporates endogenous default in a continuous time setting and assesses the interaction of default and leverage. In our heterogeneous agent model, productive experts face leverage constraints and aggregate risk, borrow from less productive households and choose whether to default. We establish a positive correlation between default and borrowing costs, hence a positive default premium. Moreover, increased default lowers experts’ capital holdings and suppresses investment, thus resulting into constrained inefficient equilibria. Finally, we show how, in the presence of leverage constraints, lower penalties can considerably decrease the time the economy spends in the inefficient region.

Keywords: Bankruptcy Code, General Equilibrium, Incomplete Markets

JEL Classification: E13, E32, E44, E52, G01, G12, G20

Suggested Citation

Papamichalis, Theofanis and Tsomocos, Dimitrios P. and Romanidis, Nikolaos, The Persistence of Investment Inefficiencies: The Dynamics of Default and Endogenous Leverage (October 24, 2021). Available at SSRN: https://ssrn.com/abstract=3949091 or http://dx.doi.org/10.2139/ssrn.3949091

Theofanis Papamichalis (Contact Author)

University of Cambridge ( email )

Austin Robinson Building
Sidgwick Ave
Cambridge, Cambridgeshire CB3 9DD
United Kingdom

Dimitrios P. Tsomocos

University of Oxford - Said Business School and St. Edmund Hall ( email )

Park End Street
Oxford, OX1 1HP
Great Britain
+44 1865 288 932 (Phone)
+44 1865 288 805 (Fax)

Nikolaos Romanidis

University of Oxford - Said Business School ( email )

Park End Street
Oxford, OX1 1HP
Great Britain

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