Default recovery rates in the US are highly volatile and pro-cyclical. We show that state-of-the-art models with a Bernanke-Gertler-Gilchrist financial accelerator mechanism imply that recovery rates are flat over the cycle. We propose a model where financially-constrained entrepreneurs face an...

In models with financial frictions, state-contingent contracts stabilize the business cycle relative to contracts with predetermined rates. We show that this finding depends on whether predetermined rates are set in real or nominal terms. State-contingent contracts can amplify supply-driven...