Journal Article

Costly External Finance and Labor Market Dynamics


  • Chugh
  • S.K.
Publication Date

We study the role of agency frictions and costly external finance in cyclical labor market dynamics, with a focus on how credit-market frictions may amplify aggregate TFP shocks. The main result is that aggregate TFP shocks lead to large fluctuations of labor market quantities if the model is calibrated to the empirically-observed countercyclicality of the finance premium. A financial accelerator mechanism thus amplifies labor market fluctuations. In contrast, if the finance premium is procyclical, which the model can be parameterized to accomodate, amplification is absent, and labor-market fluctuations display the Shimer (2005) puzzle. The cyclicality of the finance premium in the model is governed by the degree of "technology spillover" from aggregate TFP to firms' idiosyncratic productivity. If positive shocks to aggregate TFP on average improve firms' idiosyncratic productivity, a correlation that has support in firm-level studies of productivity, equilibrium labor-market fluctuations are amplified through two channels. One channel is a direct productivity channel – firms are on average more productive for a given size positive aggregate shock than if there were no productivity correlation. The second channel is a financial conditions channel, through which improved firm-level productivity reduces the risk of bankruptcy, which dampens the external finance premium and lowers firms' financing costs. Both channels induce firms to expand activity, including hiring, more sharply than if there were no productivity correlation. Sixty percent of the model's amplification comes through the financing channel, and 40 percent of the model's amplification comes through the productivity channel.


JEL Classification
E32, E44, J63, J64

Key Words

  • business cycle modeling
  • credit frictions
  • financial accelerator
  • labor search and matching
  • risk shocks
  • volatility puzzle