Financial distress and the business cycle

In this paper we argue that firms' financial distress should play a greater role in the macroeconomic analysis of the business cycle. We provide a non -technical account of a general equilibrium model that exhibits financially -driven equilibrium cycles. We show that the empirical evidence is widely s upportive of the key hypothesis and implications of our approach. We use th e model in order to evaluate the effects of several policy measures. It tur ns out that deepening the market for second-hand capital goods, subsidizing the interest payments of companies which start lip when financial conditio ns are right, and bailing our some companies in default can indeed 'stabili ze' the economy. By way of generalization we may say that the policy reacti on to a financially driven bust should be accommodating.