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BPEA Article

Interest Rates, Inflation, and Corporate Financial Policy

Abstract

RECENT high levels of interest rates have had many effects on the economy. One particularly dramatic phenomenon associated with these high interest rates is an extraordinarily high bankruptcy rate. A related observation is that during the 1970s both corporate debt-value ratios and nominal interest rates were nearly double their previous postwar values.' The purpose of this paper is to analyze the possible economic links between interest rates, inflation, corporate financial policy, and the corporate bankruptcy rate in order to explain the above associations. The primary focus is on the role of interest rates and inflationi n theoretical models of corporate financial policy. The paper provides an analysis of how changes in interest rates or inflation can lead to both higher debt-value ratios and a higher bankruptcy rate; it also gives empirical estimates of the relative importance of expected interest rates and inflation and unexpected changes in interest rates and inflation in explaining the level and composition of corporate debt.

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