Equilibrium Credit Spreads and the Macroeconomy∗

The Great Recession of 2008-09 offers a primary example of the importance of credit risk to the macroeconomy. This paper develops a novel framework that brings together core ideas from as-set pricing, capital structure, and macroeconomics within a tractable general equilibrium model with heterogeneous firms making optimal investment and financing decisions under uncertainty. Because credit risk premia are an important component of the cost of capital, movements in bond markets are propagated into the real economy generating a strong correlation between spreads and macro aggregates and producing large and skewed business cycles, with sharper, more pronounced, recessions