Corporate leverage and monetary policy effectiveness in the euro area

Abstract

We study the relationship between corporate leverage and the sensitivity of industrial production to monetary policy shocks within the euro-area manufacturing sector. Using polynomial state-dependent local projections, we document a non-linear association. More indebted industries tend to adjust their production more strongly in response to a monetary policy shock, consistently with a financial accelerator framework. At high leverage ratios, this positive relation weakens until it reaches a point where additional leverage is associated with a decrease in sensitivity to monetary policy. We show that this dampening effect is particularly intense within the short-term horizon and in recessions; it emerges with both expansionary and contractionary shocks. Our results are consistent with recent studies analyzing the role of default risk in dampening the financial accelerator mechanism.