Paper Price Rigidities and Credit Risk

We develop a capital structure model in which firms differ in their ability to adjust output prices. Firms with inflexible prices are more exposed to nominal and real shocks, leading to lower leverage, shorter debt maturity, higher cost of debt, tighter covenants, and greater precautionary cash holdings. Shocks to cash-flow volatility raise the cost of debt more for firms with less pricing flexibility. We empirically confirm these predictions: firms with inflexible prices experience significantly larger increases in credit spreads following monetary policy shocks and the 2008 Lehman Brothers bankruptcy, especially when they face high pre-shock rollover risk.

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