This paper studies the role of agency frictions and costly external finance in the dynamics of labor markets. The focus is on how credit-market frictions may amplify neutral technology shocks. The environment in which we study this question brings together a benchmark business-cycle model of financial frictions and a benchmark business-cycle model of labor search and-matching frictions. The main result is that aggregate technology shocks can lead to large cyclical fluctuations of labor market quantities in particular, unemployment, vacancies, and labor-market tightness, the quantities identified by Shimer (2005) as failing to be explained by standard search models. Our framework quantitatively accounts for the empirically observed large fluctuations of labor markets very well, even though it is calibrated to the cyclical nature of financial conditions rather than to the cyclicality of labor markets.
The property of the model economy that is crucial for amplification is a countercyclical external finance premium. In a version of the model featuring instead a procyclical external finance premium which the model can be parameterized to accommodate no amplification occurs, and the model displays the Shimer (2005) volatility puzzle. A broad message of the paper is thus that costly external finance can play an important role in amplifying shocks into the labor market, but it is not financing frictions per se that are important. Rather, the cyclical behavior of financing costs is crucial for the amplification mechanism.
The cyclicality of the finance premium is governed by a single parameter in the model economy, the elasticity of firms’ idiosyncratic productivity with respect to aggregate total factor productivity (TFP). Once this parameter is selected via simulated method of moments to match U.S. empirical evidence on the dynamics of the finance premium in particular, a contemporaneous cyclical correlation with GDP of about -0.50 — all other parameters regarding credit markets and labor markets hardly matter quantitatively for the response of the labor market to shocks to aggregate TFP. Furthermore, the model’s predictions of the cyclical fluctuations of key labor market quantities matches extremely well cyclical fluctuations observed in the U.S., even though the model is calibrated to match the cyclical properties of the finance premium, not to match the cyclical properties of labor markets. The amplification the model displays is thus not merely qualitative in nature, but also a very good quantitative fit.
Contents
1 Introduction
2 Model
2.1 Households
- 2.1.1 Pseudo-LFP Model
2.1.2 LFP Model
2.2 Firms
- 2.2.1 Firm Financing and Contractual Arrangement
2.2.2 Firm Profit Maximization
2.2.3 Entrepreneurial Capital Accumulation
2.3 Wage Bargaining
2.4 Government
2.5 Matching Technology
2.6 Private Sector Equilibrium
3 External Finance Premium and Productivity Correlation
4 General Equilibrium Consumption-Labor Margin
5 Quantitative Analysis
5.1 Parameterization
5.2 Steady-State Analysis
5.3 Basic Business Cycle Dynamics
5.4 Cyclicality of the Finance Premium and Labor Market Dynamics
5.5 The Scope of Financing Requirements
5.6 Wage Dynamics
6 A Large Adverse Shock
7 Further Quantitative Experiments
7.1 A “European Experiment:” High Labor Income Taxes
7.2 Non-Constant Returns in Recruiting Technology
7.3 Fixed Labor Force Participation
7.4 Bargaining Power
7.5 Varying Other Financial Market Parameters
8 Conclusion
A Deriving the Pseudo-Labor-Force Participation Condition
B Nash Bargaining
C General Equilibrium Consumption-Leisure Margin
D Competitive Search Equilibrium
E Steady State as Function of Bargaining Power
