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03 Feb 2007

Agency Costs and Investment Behaviour

Viktor Dorofeenko / Gabriel S. Lee / Kevin D. Salyer

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European Network of Economic Policy Research Institutes (ENEPRI) Working Paper No. 47 / 44 pages

How do differences in the credit channel affect investment behaviour in the U.S. and the Euro area? To analyze this question, we calibrate an agency cost model of business cycles. We focus on two key components of the lending channel, the default premium associated with bank loans and bankruptcy rates, to identify the differences in the U.S. and European financial sectors. Our results indicate that the differences in financial structures affect quantitatively the cyclical behaviour in the two areas: the magnitude of the credit channel effects is amplified by the differences in the financial structures. We further demonstrate that the effects of minor differences in the credit market translate into large, persistent and asymmetric fluctuations in price of capital, bankruptcy rate and risk premium. The effects imply that the Euro Area’s supply elasticities for capital are less elastic than the U.S.