Asset Quality Dynamics

We describe a dynamic extension of Allen and Gale (1998)’s optimal security design model and provide a recursive method for computing equilibria in the resulting environment. The model is quantitatively consistent with the cyclical properties of safe corporate debt issues, in particular with the fact that those issues are less procyclical than other sources of corporate financing. It is also consistent with the countercyclicality of risk spreads on corporate debt. We then use the model to measure the effect of a protracted periods of low safe yields, one of the main features of the so-called “saving glut” the global economy is currently experiencing. A long period of low interest rates on safe debt has little impact on the level of economic activity but causes output and investment volatility to fall.