Credit Risk and Business Cycles

Abstract

We incorporate long-term defaultable corporate bonds and credit risk in a dynamic stochastic general equilibrium business cycle model. Credit risk ampli¯es aggregate tech- nology shocks. The debt-capital ratio is a new state variable and its endogenous movements provide a propagation mechanism. The model can match the persistence and volatility of output growth as well as the mean equity premium and the mean risk-free rate as in the data. The model implied credit spreads are countercyclical and forecast future economic activities because they a®ect ¯rm investment through Tobin's Q. They also forecast future stock returns through changes in the market price of risk. Finally, we show that ¯nancial shocks to the credit markets are transmitted to the real economy through Tobin's Q.