What is the macroeconomic effect of having a substantial number of firms close to default? This paper studies the effects of financial distress in a model where customers, suppliers and workers suffer losses if their employer goes bankrupt. I show that this mechanism generates amplification of fundamental shocks by creating a cyclical TFP and labor macroeconomic wedges. Because the strength of this amplification depends on the share of firms that are in financial distress, it operates mostly in recessions, when equity values are low. This leads macroeconomic volatility to be endogenously countercyclical. Moreover, the cross-sectional dispersion of firms outcomes is also endogenously countercyclical. Empirical evidence consistent with the model is provided.(Draft)

JEL: E32, E44, G12.
Keywords: time-varying uncertainty, uncertainty shocks, distance-to-default, leverage.

Please find paper HERE.