Inflation and Asset Prices

Do corporate bond spreads reflect fear of debt deflation? Most corporate bonds have fixed nominal face values, so unexpectedly low inflation raises firms' real debt burdens and increases default risk. The first chapter develops a real business cycle model with time-varying inflation risk and optimal, but infrequent, capital structure choice. In this model, more volatile or more procyclical inflation lead to quantitatively important credit spread increases. This is true even with inflation volatility as moderate as that in developed economies since 1970. Intuitively, this result obtains because inflation persistence generates large uncertainty about the price level at long maturities and because firms cannot adjust their capital structure immediately.