Costly Default and Skewed Business Cycle

Abstract

We augment a simple Real Business Cycle model with financial intermediaries that may default on their liabilities and a financial friction generating social costs of default. We provide a closed-form solution for the general equilibrium of the economy under specific assumptions, allowing for analytic results and straightforward simulations. Endogenous default generates asymmetric business cycles and our model replicates both the negative skew of GDP and the positive skew of credit spreads found in US data. Stronger financial frictions cause a rise in asymmetry and amplify the welfare costs of default. A Pigouvian tax on financial intermediation mitigates most of these negative effects at the cost of a steady-state distortion.

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JEL codes

Replaces

Patrick Fève, Pablo Garcia Sanchez, Alban Moura, and Olivier Pierrard, “Costly default and asymetric real business cycles”, TSE Working Paper, n. 19-1048, November 2019.

Reference

Patrick Fève, Pablo Garcia Sanchez, Alban Moura, and Olivier Pierrard, “Costly Default and Skewed Business Cycle”, European Economic Review, vol. 132, February 2021.