Corporate Credit Spreads and Business Cycles∗

I study the implications of fluctuations in corporate credit spreads for TFP and output. Motivated by that corporate credit spreads are countercyclical, I build a simple model in which the difference in default probabilities on corporate debts leads to the spread in interest rates paid by firms. In the model, firms finance their capital by issuing one-period bonds, and differ in the variance of the firmlevel productivity, tightly linked to the default probability. The higher default probability for risky firms relative to safe firms results in the misallocation of capital: capital is allocated too little for risky firms and too much for safe firms. As the default probability for risky firms increases, the extent of misallocation becomes larger, and thereby TFP and output drop. I embed the basic mechanism into an otherwise standard growth model, and calibrate it to data for the post-war U.S. economy: the shock process for default probabilities for risky and safe firms are calibrated to match the fluctuations in the historical default rates of corporate bonds by credit ratings. In my benchmark simulation results, I find that shocks to the distribution of default probabilities across firms can account for about 60% of output fluctuations and 90% of TFP fluctuations in the U.S. economy. In addition, I find that the misallocation mechanism proposed in my paper is supported by the firm-level investment data. ∗I am greatly indebted to Richard Rogerson, my advisor, for his advice and encouragement. I also thank seminar participants at Arizona State University. All errors are mine. †Contact: Department of Business Administration, School of Business, ITAM, D.F., Mexico.