Interaction of Labor and Credit Market Frictions: A Theoretical and Empirical Analysis

In this paper we investigate macroeconomic dynamics in the presence of frictions in both labor and credit markets. On the basis of the macroeconomic model in Merz (1995) with labor market frictions and capital accumulation, our paper offers an extension to frictions in credit markets which, analogously, are modeled as a search-and-matching process. Using the Merz model as limit case, we consider exogenous as well as endogenous borrowing constraints. We show that capital market frictions exacerbate and accentuate the interaction between the two markets, amplifying effects on output, consumption, employment, and welfare. This interaction of the frictions in labor and capital markets is shown to potentially give rise to multiple steady states. The steady state solutions are studied by using the Hamiltonian, and the dynamics are assessed for various model variants using dynamic programming. Since the model predicts high and low level steady states, the empirical implications of the model are assessed by fitting a Multi Regime VAR (MRVAR) model U.S. output and interest– rate spread. The MRVAR estimation indicates that shocks to credit frictions during a boom period have markedly different effects than during a recession. Also, there are substantial state-dependent asymmetries with respect to the sign of shocks to credit friction.