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We present evidence on the cyclical behavior of small versus large manufacturing firms, and on the response of the two classes of firms to monetary policy. Our goal is to take a step toward quantifying the role of credit market imperfections in the business cycle and in the monetary transmission mechanism. We find that, following tight money, small firms sales decline at a faster pace than large firm sales for a period of more than two years. Further, bank lending to small firms contracts, while it actually rises for large firms. Monetary policy indicators tied to the performance of banking, such as M2, have relatively greater predictive power for small firms than for large.Finally, small firms are more sensitive than are large to lagged movements in GNP. Considering that small firms overall are a non-trivial component of the economy, we interpret these results as suggestive of the macroeconomic relevance of credit market imperfections.

Using micro-level data, we construct a credit spread index with considerable predictive power for future economic activity. We decompose the credit spread into a component that captures firm-specific information on expected defaults and a residual component–– the excess bond premium. Shocks to the excess bond premium that are orthogonal to the current state of the economy lead to declines in economic activity and asset prices. An increase in the excess bond premium appears to reflect a reduction in the risk-bearing capacity of the financial sector, which induces a contraction in the supply of credit and a deterioration in macroeconomic conditions.

Adverse shocks to the economy may be amplified by worsening credit-market conditions-the financial "accelerator". Theoretically, we interpret the financial accelerator as resulting (mm endogenous changes over the business cycle in the agency costs of lending. An implication of the theory is that, at the onset of a recession. boirowers facing high agency costs should receive a relatively lower share of credit extended (the flight to quality) and hence should account for a proportionally greater part of the decline in economic activity. We review the evidence for these predictions and present new evidence drawn from a panel of large and small manufacturing finns.

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provided outstanding research assistance at various stages of the project. All errors and omissions are our own responsibility alone. The views expressed in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System, anyone else associated with the Federal Reserve System, or the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peerreviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.

We re-examine the evidence on the relationship between credit spreads and economic activity, by constructing a credit spread index based on an extensive data set of prices of outstanding corporate bonds trading in the secondary market. Compared with the standard default-risk indicators, our credit spread index is a robust predictor of economic activity at both the short-and longer-term horizons. Using an empirical framework, we decompose the index into a predictable component that captures the available firm-specific information on expected defaults and a residual component-the excess bond premium-which we argue likely reflects variation in the price of default risk rather than variation in the risk of default. Our results indicate that the predictive content of credit spreads for economic activity is due primarily to movements in the excess bond premium. Innovations in the excess bond premium that are orthogonal to the current state of the economy are shown to lead to significant declines in economic activity and equity prices. We also show that a deterioration in the creditworthiness of broker-dealers-key financial intermediaries in the corporate cash market-causes an increase in the excess bond premium. These findings support the notion that a rise in the excess bond premium represents a reduction in the effective risk-bearing capacity of the financial sector and, as a result, a contraction in the supply of credit with significant adverse consequences for the macroeconomy.

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