Credit Markets, Intermediate Production and the Business Cycle

This paper builds an RBC model with an endogenous mechanism for firm defaults andcredit spreads. The model assumes a productive sector made of a class of intermediate producers and a class of final producers. The intermediate producers borrow to fund their operations and can default when large enough negative shocks affect their revenues. The intermediate/final production structure implies that during periods of low economicactivity, the demand for the intermediate good is lower. This depresses the price of theintermediate good and in turn depresses the revenues of the borrowing firms. Hence, higher default rates during the lows of the business cycle. Inversely, default rates are lower whenthe economy is improving: default rates are countercyclical. Intermediate producers are financed by banks that take future defaults into account when setting lending rates. This guarantees that credit spreads are countercyclical too.