Financial Frictions, Financial Shocks and Unemployment Volatility

38 Pages Posted: 9 Jun 2015

See all articles by Tito Boeri

Tito Boeri

Bocconi University - Department of Economics; Centre for Economic Policy Research (CEPR); IZA Institute of Labor Economics

Pietro Garibaldi

University of Turin - Faculty of Economics

Espen R. Moen

BI Norwegian Business School; Centre for Economic Policy Research (CEPR)

Date Written: June 2015

Abstract

Financial market shocks and imperfections, alongside productivity shocks, represent both an impulse and a propagation mechanism of aggregate fluctuations. When labor and financial markets are imperfect, firms' funding and leverage respond to productivity changes. Models of business cycle with equilibrium unemployment largely ignore financial imperfections. The paper proposes and solves a tractable equilibrium unemployment model with imperfections in two markets. Labor market frictions are modeled via a traditional Diamond Mortensen Pissarides (DMP) model with wage positing. Financial market imperfections are modeled in terms of limited pledgeability, in line with the work of Holmstrom and Tirole. We show analytically that borrowing constraints increase unemployment volatility in the aftermath of productivity shocks. We calibrate the model to match key labor and financial moments of the US labor markets, and we perform two quantitative exercises. In the first exercise we ask whether the interaction between productivity shocks and borrowing constraints increase the volatility of unemployment with respect to models that focus only on the labor market imperfections. In the general specification of the model, both leverage and non pledgeable income move with the cycle. Our calibration exercise shows that the volatility of unemployment in response to productivity shock increases by as much as 50 percent with respect to a pure DMP model with wage posting. The second quantitative exercise explores the role of pure financial shocks on aggregate equilibrium. We calibrate pledgeability shocks to match the frequency of financial crisis and define financial distress as a situation in which internal liquidity completely dries up. The second exercise shows that full dry up of internal liquidity implies an increase in unemployment as large as 60 percent. These results throw new light on the aggregate impact of financial recessions.

Keywords: financial frictions, search, unemployment volatility

JEL Classification: J00

Suggested Citation

Boeri, Tito and Garibaldi, Pietro and Moen, Espen R., Financial Frictions, Financial Shocks and Unemployment Volatility (June 2015). CEPR Discussion Paper No. DP10648, Available at SSRN: https://ssrn.com/abstract=2615888

Tito Boeri (Contact Author)

Bocconi University - Department of Economics ( email )

Via Gobbi 5
Milan, 20136
Italy

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

IZA Institute of Labor Economics ( email )

P.O. Box 7240
Bonn, D-53072
Germany

Pietro Garibaldi

University of Turin - Faculty of Economics ( email )

Facoltà di Economia
Corso Unione Sovietica 218 bis
Torino, 10134
Italy

Espen R. Moen

BI Norwegian Business School ( email )

Nydalsveien 37
Oslo, 0442
Norway

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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