The Cyclical Volatility of Labor Markets under Frictional Financial Markets

Abstract

We provide a dynamic extension of an economy with search on credit and labor markets (Wasmer and Weil, 2004). Financial frictions create volatility: they add an additional, almost acyclical, entry cost to procyclical job creation costs, thus increasing the elasticity of labor market tightness to productivity shocks by a factor of 5 to 8, compared to a matching economy with perfect financial markets. We characterize a dynamic financial multiplier, that is increasing in total financial costs and minimized under a credit market Hosios-Pissarides rule. Financial frictions are an element of the solution to the volatility puzzle.

Keywords: Search, Financial Market Imperfections, Shimer Puzzle, Macroeconomic Volatility

JEL Classification: E32, E44, J63, J64