Debt overhang in a business cycle model

We study the macroeconomic implications of the debt overhang distortion on firms' investment and labor decisions. We show that the distortion arises when the levels of investment and labor are non-contractible and chosen after the signing of the debt contract. The financial friction manifests itself as investment and labor wedges that move counter-cyclically, increasing during recessions when the risk of default is high. Their dynamics amplify and propagate the effects of shocks to productivity, government spending, volatility, and funding costs. Both the size and the persistence of these effects are quantitatively important. (C) 2014 Elsevier B.V. All rights reserved.