On Balance Sheets, Idiosyncratic Risk and Aggregate Volatility

Since the mid-1980s firm level financial volatility has increased, while the U.S. economy has experienced a sharp decline in the volatility of GDP growth. Do firms adjust their capital structure in response to higher idiosyncratic risk? And if so, could that affect the performance of the aggregate economy? Using a dynamic general equilibrium model we show that in the presence of larger firm-specific risk, firms shift the composition of their balance sheets towards more self-financing and away from debt. In the presence of financial accelerator-like frictions, larger idiosyncratic risk translates into greater external financing costs, steering firms to borrow less to counteract larger premia. Model simulations suggest that larger idiosyncratic risk dampens the financial accelerator and can lead to a reduction in output volatility of up to 40 percent; and up to a 16 percent decline in firm leverage.