DP5697 Financial Structure and Macroeconomic Volatility: Theory and Evidence

Author(s): Harry Huizinga, Dantao Zhu
Publication Date: June 2006
Keyword(s): bankruptcy costs, financial structure, macroeconomic volatility
JEL(s): C24, E32, E44, G33
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5697

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.