The magnitude and Cyclical Behavior of Financial Market Frictions

6 Directions for Future Research

In future research we plan to extend our work in several directions. From an empirical
point of view, we plan to use our new firm-level dataset to investigate the degree of
non-linearity and the cyclical variations of the spread-leverage schedule. This relates
to the Bernanke and Campbell’s (1988) so-called “financial fragility” argument, ac-
cording to which shocks to the economy have different effects on high- and low-debt
firms. Furthermore, we want to use our firm-level dataset to examine the link between
firm-specific credit spreads and investment expenditures.

From a theoretical point oif view, it would be interesting to consider the implica-
tions of greater heterogeneity across firms, with low-risk firms having a shallow slope
of the leverage-spread schedule and high-risk firms having a steeper schedule. We
would also like to extend the BGG framework to include some form of multi-period
debt contract 1to address the issue of the relationship between leverage and degree
of idiosyncratic risk outlined at the end of the previous section. Furthermore, we
plan to use perturbation methods to obtain second-order approximation of the model
around the steady state, characterize the optimal monetary policy, and compare the
welfare performance of alternative simple rules.

Finally, it would be interesting to extend our empirical analysis to the open econ-
omy framework, considering different measures of leverage and spread for emerging
markets.

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