Learning and Leverage Dynamics in General Equilibrium

Abstract

This paper develops and empirically tests a general equilibrium model of asset pricing, financing and investment dynamics in a trade-off economy where heterogeneous firms face unobservable "disaster" risk exposure and engage in rational Bayesian updating. The model sheds light on recent leverage cycles. During periods absent disasters [e.g. "The Great Moderation"]: equity premia decrease; credit spreads decrease; expected loss given default increases; and leverage ratios increase, especially amongst firms with high bankruptcy costs. Time since prior disasters is the key model conditioning variable. In response to a disaster, risk premia increase while firms reduce labor, capital and leverage, with response size increasing in time since prior disasters. Disaster responses are more pronounced than in an otherwise equivalent economy featuring observed disaster risk. Further, business cycles are more pronounced than in an otherwise equivalent economy with frictionless financing. Empirical tests of novel model predictions are conducted. Consistent with simulated model regressions, in the real-world data leverage and investment are increasing in time-since-prior-recessions, with the effect more pronounced for firms with low recovery ratios.