Financial Frictions and Credit Spreads

Abstract

This paper uses the credit-friction model developed by Curdia and Woodford, in a series of papers, as the basis for attempting to mimic the behavior of credit spreads in moderate as well as crisis times. We are able to generate movements in representative credit spreads that are, at times, both sharp and volatile. We then study the impact of quantitative easing and credit easing. Credit easing is found to reduce spreads, unlike quantitative easing, which has opposite effects. The relative advantage of credit easing becomes even clearer when we allow borrowers to default on their loans. Since increases in default offset the beneficial effects of credit easing on spreads, the policy implication is that, in times of financial stress, the central bank should be aggressive when applying credit easing policies.Credit easing, credit spread, financial friction, quantitative easing.