by Nicolas Aragon and Pablo Forero

This paper develops a simple model of heterogeneous firms and households. Households finance firm's working capital, and firms are credit constrained and differ in their debt levels. When there is an aggregate shock, less productive firms go bankrupt. This directly decreases the demand for labor and the wage receipts for households and indirectly decreases income from the defaulted loans to firms. The main result of the paper is that there is an optimal haircut for deposits such that both firms and families are better off. Moreover, there is a tension between maximizing welfare and maximizing output. This provides a rationale for the Cyprus, Greek and Argentinean experience. We extend the model to an open economy and show an equivalence result. The model is also extended to infinite horizon to perform a quantitative exercise for the Argentinean devaluation episode of 2001.