Liquidity Frictions and Unemployment Fluctuations

Abstract: We develop a model in which firms need liquidity to meet their wage bill before production occurs and face a limit on how much they can borrow. Both frictions operate within a standard search-and-matching labor market. Their interaction generates an endogenous wedge on the effective cost of hiring: when credit conditions tighten, the shadow cost of financing wages rises, making each new hire more expensive than the wage alone would suggest. Firms respond by cutting vacancy posting sharply, amplifying the labor market response to aggregate shocks beyond what a frictionless benchmark would predict. We apply the framework to two unresolved puzzles in the labor macro literature. First, the model aims at replicating the unemployment volatility documented by Shimer (2005): binding financial constraints amplify the response of vacancies and unemployment to productivity shocks, bringing the model closer to the data. Second, when a shock simultaneously depresses productivity and tightens credit, the model aims at replicating the slow employment recovery observed after GFC — producing a debt overhang in which balance-sheet repair keeps hiring suppressed long after output recovers.