Aggregate demand externality and self-fulfilling default cycles

Abstract

Recurrent clustered episodes of corporate default are a long-standing puzzle that standard models driven by observable fundamentals struggle to explain. We develop a general equilibrium model where demand externality generates such default cycles endogenously through a self-fulfilling mechanism. In our framework, a decline in aggregate output reduces individual firm revenues and values, raising default risk. The subsequent exit of defaulting firms further depresses aggregate output, creating a positive feedback loop and pessimistic expectations about defaults can become self-fulfilling. This mechanism generates multiple equilibria and features endogenous, sentiment-driven default cycles. A global dynamic analysis using Bogdanov–Takens bifurcation reveals a rich set of dynamics, including periodic orbits, that are overlooked by standard local analysis. Our framework thus provides a microfounded explanation for business cycle patterns driven by internal economic forces, as emphasized by the empirical literature of endogenous business cycles.