Credit Risk Model Taking Account of Inflation and Its Contribution to Macroeconomic Discussion on Effect of Inflation on Output Growth

Abstract

We use Extended Merton model (EMM) for estimating the firm’s credit risks in the presence of inflation. We show quantitatively that inflation is an influential factor making either a benign or adverse effect on the firm’s survival, supporting at the microeconomic level New Keynesian findings of the nonlinear inflation effect on output growth. Lower inflation increasing the firm’s expected rate of return can raise its mean year returns and decrease its default probability. Higher inflation, decreasing the expected rate return, makes the opposite effect. The magnitude of the adverse effect depends on the firm strength: for a steady firm, this effect is small, whereas for a weaker firm, it can be fatal. EMM is the only model taking account of inflation. It can be useful for banks or insurance companies estimating credit risks of commercial borrowers over the debt maturity, and for the firm’s management planning long-term business operations.