Nominal corporate debt, default and inflation

This paper investigates how the effectiveness of interest rate policy on prices changes if firms can file for bankruptcy and restructure their debt out-of-court before uncertainty realises in a two-agent general equilibrium model with money, non-diversifiable idiosyncratic firm risk and nominal debt. I find that if a small, but not-too-small fraction of firms file for bankruptcy, interest rate policy is most effective. A larger interest rate always increases debt-to-output. This reduces the wealth of the firm owners when they do not file for bankruptcy, but does not affect their wealth when they do file for bankruptcy. As bankruptcy states are those where labour is least productive, this raises real equilibrium wages as firm owners are willing to pay more for labour. The higher wages directly increases the wage bill. Indirectly, labour supply increases pushing it down further. In turn, prices fall as working capital needs to be borrowed taking demand out of the economy.