Sticky Leverage

This paper considers the macroeconomic effects of allowing for nominal debt contracts in the context of a quantitative business cycle model with financial market frictions. In our setting, as in reality, corporations fund themselves by choosing the appropriate mix of nominal defaultable debt and equity securities to issue in every period. Corporate debt is priced fairly taking into account default and inflation risk, but is attractive because of the tax-deductibility of interest payments. We show that in this world unanticipated shocks to inflation will both change the real burden of corporate debt and, more significantly, also distorts corporate investment and production decisions. Unlike sticky prices and wages, the effects of having nominal leverage can be both large and persistent if the model is calibrated to match empirically observed debt levels and maturities. Finally, we show that the adoption of a standard Taylor-rule for nominal interest rates can substantively stabilize this economy, supporting perhaps its current popularity with monetary policy makers. ∗Joao Gomes and Urban Jermann are at The Wharton School of the University of Pennsylvania. Lukas Schmid is at the Fuqua School at Duke University; We thank participants at Wharton School for valuable comments and suggestions. All errors are our own.