Financial Markets and Unemployment

Abstract

We study the importance of financial markets for (un)employment fluctuations in a model with searching and matching frictions where firms issue debt under limited enforcement. Higher debt allows employers to bargain lower wages which in turn increases the incentive to create jobs. The transmission mechanism of ‘credit shocks’ is different from the typical credit channel and the model can explain why firms cut hiring after a credit contraction even if they do not have shortage of funds for hiring. The empirical relevance of these shocks is validated by the structural estimation of the model. The theoretical predictions are also consistent with the estimation of a structural VAR whose identifying restrictions are derived from the theoretical model.

Keywords: limited enforcement, wage bargaining, unemployment, credit shocks

JEL Classification: E24, E32, E44