Munich Personal RePEc Archive

Corporate Default, Investment, and the U.S. Great Depression

Jiang, Lunan (2014): Corporate Default, Investment, and the U.S. Great Depression.

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Abstract

This paper investigates the role of corporate bond default risk during the U.S. Great Depression, and propose that the default risk is an effective amplifier of adverse technology and financial shocks. On the one hand, the massive wave of corporate bond defaults directly idled a considerable amount of capital, which was detrimental to production, investment, and employment. On the other hand, the indebted firms were inclined to cut more investment during the economic downturn, as they were also concerned about the increasing default risks besides the awful economic outlook. Based on the prominent work by Cooley and Quadrini(2001) and Miao and Wang(2010), I build a rational expectations DSGE model with firm default risk, which generates simulated investment dynamics that are much closer to the actual 1930s data series than in the standard RBC model. The model also predicts satisfactory declines in consumption, working hours and output. Moreover, I find that the default recovery rate decline caused by adverse financial shocks explains well the increasing corporate bond yield in the early 1930s.

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