Financial Aspects of Business Cycles: An Analysis of Balance Sheet Adjustments of U.S. Nonfinancial Enterprises over the Twentieth Century

This paper formulates and tests a model of asset and financing adjustments of nonfinancial enterprises over the twentieth century. Asset adjustments change the expected income and operating risk of firms while financing adjustments change financial risk. To protect debt and equity investors from a conflict of interest problem, an up‐front contract develops an “assignment” rule for managing the firm's balance sheet whereby managers make investment decisions that conform to the risk aversion of stockholders and financing decisions that offset changes in operating risk resulting from investment decisions. Empirical evidence gathered in this paper fails to reject the predictions of the model.