Abstract
This paper describes the balance sheet adjustments of debt and equity financed firms over the business cycle. A model is developed that describes a representative firm with a stochastic diminishing returns technology and a set of financial contracts that resolves a conflict of interest problem between differentially risk-averse bondholders and stockholders. The contractual resolution of this conflict of interest problem is shown to shape certain stylized facts of business cycles ignored in Keynesian and Classical models. Changes in the market value of equities trigger investment decisions and can cause business cycles. Bond covenants then have the firm adjusting its financing decisions so as to offset any risk-shifting associated with the investment decisions. Stockholders manage the asset side of the firm's balance sheet while bondholders (regulators in the case of banks) manage the financing side. In this way the welfare of both investors is coalesced over the business cycle. Evidence presented here and elsewhere fails to reject these predictions for the U.S. non-financial and financial corporate sectors.
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