Default risks, interest rate spreads, and business cycles: Explaining the interest rate spread as a leading indicator

The interest rate spread between risky loan rates and risk-free rates has been shown to have high predictive power for subsequent fluctuations in real output. This paper examines the relationship between the interest rate spread and default risk and how this relationship may generate the leading behavior of the interest rate spread over the business cycle within a general equilibrium model that includes a financial intermediary. This study shows that the interest rate spread may contain information on future fluctuations in output when investment decisions are inflexible to adjust to a new shock. (C) 2002 Elsevier Science B.V. All rights reserved.