August 2010

IZA DP No. 5131: The Cyclical Volatility of Labor Markets under Frictional Financial Markets

published in: American Economic Journal: Macroeconomics, 2012, 5 (1), 193-221

Financial frictions are known to raise the volatility of economies to shocks (e.g. Bernanke and Gertler 1989). We follow this line of research to the labor literature concerned by the volatility of labor market outcomes to productivity shocks initiated by Shimer (2005): in an economy with search on credit and labor markets, a financial multiplier raises the elasticity of labor market tightness to productivity shocks. This multiplier increases with total financial costs and is minimized under a credit market Hosios-Pissarides rule. Using a flexible calibration method based on small perturbations, we find the parameter values to match the US share of the financial sector. Those values are far away from Hosios and lead to a financial accelerator of about 3.6 (exogenous wages) to 4.5 (endogenous wages). Both match Shimer (2005)'s elasticity of labor market tightness to productivity shocks. Financial frictions are thus an alternative to the "small labor surplus" assumption in Hagedorn and Manovskii (2008): we keep the value of wages over productivity below 0.78. We conclude that financial frictions are a good candidate to solve the volatility puzzle and rejoin Pissarides (2009) in arguing that hiring costs must be partly non-proportional to congestion in the labor market, which is the case of financial costs.