Sticky Leverage

We examine the effects of long-lived nominal debt contracts in a quantitative business cycle model with financial frictions. In our set-ting, as in reality, firms fund themselves with a mix of nominal default-able debt and equity securities to issue in every period. Debt is priced fairly taking into account default and inflation risk, but is attractive because of the tax-deductibility of interest payments. Unanticipated inflation changes the real burden of corporate debt and, more signifi-cantly, distorts corporate investment and production decisions. These effects are large and very persistent. Interest rates rules stabilize the economy, supporting their popularity with policy makers. (Key words: Debt deflation, debt overhang, monetary non-neutrality