Corporate Leverage and Household Portfolio Preference

Abstract

In an economy in which there are only two sectors, corporations and households, the ratio of debt to equity must be the same in both. If households wish to hold more debt, companies must become more leveraged. Because there are large differences in price elasticities the adjustment occurs through changes in bond yields, rather than in equity returns. Corporate leverage is endogenous and equilibrium is achieved, when fiscal policy and portfolio preference alter, by its response to them via changes in bond yields. Fiscal deficits vary with the cycle, but the possibility of different secular levels rests on the assumption that the economy has more than one possible equilibrium. This is implied by the neoclassical consensus though, due to its failure to recognize the need for the balance between portfolio preference and leverage, there is no analysis on whether the output of economies operating under these different equilibria will grow at different rates. The model explains how this balance is achieved and indicates that an economy with a fiscal deficit and higher interest rates will tend to grow more slowly than one with smaller deficits and lower long-term interest rates.