The Persistence of Investment Inefficiencies: The Dynamics of Default and Endogenous Leverage

Abstract

We propose a tractable framework that incorporates endogenous default in a continuous time setting and assesses the interaction of default and leverage. In our heterogeneous agent model, productive experts face leverage constraints and aggregate risk, borrow from less productive households and choose whether to default. We establish a positive correlation between default and borrowing costs, hence a positive default premium. Moreover, increased default lowers experts’ capital holdings and suppresses investment, thus resulting into constrained inefficient equilibria. Finally, we show how, in the presence of leverage constraints, lower penalties can considerably decrease the time the economy spends in the inefficient region.