Asset Quality Dynamics

We describe a dynamic extension of Allen and Gale (1998)'s optimal security design and provide a recursive method for computing equilibria in the resulting environment. The model is quantitatively consistent with the cyclical properties of safe corporate debt issues, in particular with the fact that those issues are less procyclical than other sources of corporate financing. We then use the model to measure the effect of a protracted period of low safe yields, one of the main features of the so-called ``saving glut'' the global economy is currently experiencing. A long period of low interest rates on safe debt causes GDP volatility to go down while, on the other hand, consumption and household income volatility increase significantly.