Working Paper: CEPR ID: DP5697
Authors: Harry Huizinga; Dantao Zhu
Abstract: This paper presents a simple model capturing differences between debt and equity finance to examine how financial structure matters for macroeconomic volatility. Debt finance is relatively cheap in the sense that debt holders need to verify relatively few profitability states, but debt finance may lead to costly bankruptcy. At the aggregate level, a more debt-based financial structure leads to a higher bankruptcy rate. Therefore, aggregate output is more variable in case of a heavy reliance on debt finance. This paper provides empirical evidence that countries with more equity finance have a lower variance of GDP and a lower probability of episodes of negative economic growth.
Keywords: bankruptcy costs; financial structure; macroeconomic volatility
JEL Codes: C24; E32; E44; G33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| debt finance (G32) | higher variance of GDP (E20) |
| higher bankruptcy rates (K35) | higher variance of GDP (E20) |
| more leveraged financial structure (G32) | increased GDP volatility (F69) |
| more equity finance (G32) | lower GDP variance (E20) |
| debt costs during economic contractions (H63) | GDP volatility (E39) |
| credit market size (G10) | likelihood and severity of downturns (E32) |
| stock market size (G10) | probability and severity of negative growth (F69) |
| credit market development (O16) | GDP volatility (E39) |