Cole and Rogerson (1999) and Shimer (2005) have investigated the cyclical properties of the search matching models following Pissarides (1985) and Mortensen and Pissarides (1994). The celebrated Shimer’s puzzle is the demonstration of the inability of the conventional matching model to replicate the US statistics regarding the volatility of job vacancies, unemployment and their ratio (called labor market tightness), in response to productivity shocks. Shimer’s main finding is that the elasticity of labor market tightness to productivity shocks is around 20 in the data, and around 1 in a calibration of the Mortensen-Pissarides model. Several calibration improvements have been proposed. One of them, called the “small labor surplus” assumption, implies that the calibraed value of non-employment utility (Hagedorn and Manovskii 2008) becomes closer to market productivity, with only a few percentage points differences and very low values for the bargaining power of workers. This leads firms to also face a small surplus, by a few percents, after bargaining over the surplus. Firms are therefore more fragile to productivity shocks, leading the market to be overall more volatile. Other promising roads have been proposed, such as wage rigidity (Hall 2005) and on-the-job search (Mortensen and Nagypàl 2007).
One line of research that has so far been ignored but seems promising is the existence of credit market imperfections. In this paper we pursue this logic, following two previous papers. On the one hand, Petrosky-Nadeau (2009) shows that introducing credit market imperfections, with in particular costly state verification, in a search model can lead to a large amplification of the volatility of labor market tightness. The standard deviation in his model of the vacancy-unemployment ratio approaches 12.5 relative to that of output, while it is 15.4 in US data and merely 3.7 in the standard search model. Credit market imperfections induce an amplification factor of 3.5. On the other hand, Wasmer and Weil (2004), who develop financial imperfections in a Mortensen-Pissarides economy with two matching functions (one in the labor market, one in the credit market), show that the steady-state volatility of labor market tightness to profit shocks is augmented by a factor 1.7 by the existence of moderate credit market imperfections. They call this a financial accelerator, in line with an earlier literature.
Despite recent papers attempting to bring together credit market imperfections and the search-matching approach, the macro-labor literature has been slow to incorporate the well-known message of an earlier literature. Indeed, it has been known for a while that credit market imperfections generate additional volatility of the business cycle. Early papers such as Bernanke and Gertler (1989), Kiyotaki and Moore (1997) and subsequent papers (such as Bernanke and Gertler 1995, Bernanke Gertler and Gilchrist 1996, and several others), have emphasized the implification role of credit markets and the existence of a financial accelerator. Although part of this literature is centered on the role of credit shocks and the credit channel of monetary policy, the ingredients generating the amplification of credit shocks can very well be adapted to the amplification of business cycle shocks to labor markets.
Firms in our model arise from the result of the meeting of an entrepreneur and a banker on a frictional credit market. The average cost of creating a firm is the sum of all prospecting costs on the credit market which, compared to the world with perfect credit markets in Mortensen and Pissarides (1994), imposes a lower limit on the value of a job vacancy to a firm.
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The Cyclical Volatility of Labor Markets under Frictional Financial Markets
