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We develop a monetary dynamic general equilibrium model with a rich corporate finance structure to study which financial shocks drive the business cycles and how. Entrepreneurs optimally choose dividend payouts, long-term nominal debt, and real investment in a setting with idiosyncratic risk and strategic default. We model segmented asset markets and introduce sentiment shocks to the demand for corporate bonds, for corporate equity, and for default-free government bonds. On the supply side of the corporate credit market, we include an idiosyncratic entrepreneurial risk shock. We estimate the model on US data on corporate financial flows, asset prices, and standard indicators of economic activity. Sentiment shocks generate plausible business cycle responses and can explain around 20 percent of investment and employment fluctuations, comparable to the role played by the risk shock. Allowing for strategic default and an endogenous capital structure significantly amplifies the effects of a positive equity sentiment shock by lowering leverage and default risk. In contrast, entrepreneurs' use of long-term debt reduces the effect of a positive bond sentiment shock because a large fraction of the benefits accrue to existing bondholders.
