The Transmission of Uncertainty Shocks through Firm Default Choices and Costs

Default risks amplify and propagate the effects of aggregate uncertainty shocks, leading to a decrease in aggregate investment and output. Following an aggregate uncertainty shock, large firms with high default risks decrease their investment to avoid default costs, which is summarized in a fraction loss of their market value. However, large firms with low default risks and small firms increase the investment. In particular, small firms increase the investment by defaulting on their repayment to gain more liquidity. The paper first provides both a causal-effect empirical evidence and heterogeneous-responses evidence for the phenomena. A heterogeneous firm model is then proposed to match the evidence in terms of both the aggregate quantities variation and heterogeneous responses, built on the mechanism of default choices and costs. Compared with the traditional adjustment costs transmission channel of uncertainty shocks, this paper pro vides a new transmission channel through default risks.