Abstract |
The Great Recession of 2008-09 was characterized by high and prolonged unemployment and lack
of bank lending. The recession was preceded by a housing crisis that quickly spread to the banking
and broader financial sectors. In this paper, we attempt to account for the depth and persistence of
unemployment during and after the crisis by considering the relationship between credit and firm hiring
explicitly. We develop a New Keynesian model with nominal rigidities in wages and prices augmented by a
banking sector characterized by search and matching frictions with endogenous credit destruction. In the
model, financial shocks are propagated and amplified through significant variation over the business cycle
in the endogenous component of the total factor productivity, the credit inefficiency gap, arising from
the existence of search and matching frictions in the credit market. In response to a financial shock, the
model economy produces large and persistent increases in credit destruction, declines in credit creation,
and overall declines in excess reallocation among banks and firms. The tightening of the credit market
results in a sharp rise in the average interest rate spread and the average loan rate. Due to the increase in
credit inefficiency that arises from the reduction in firm-bank matches, total factor productivity declines
and unemployment increases. Total factor productivity and unemployment take at least 12 quarters to
return to baseline. This result is due to a combination of nominal and real frictions. Credit frictions not
only amplify the effect of financial shocks by creating variation in the number of firms able to produce
due to credit restrictions following a shockan extensive margin effectas well as in labor demand by each
firm, but they also increase the persistence of the shocks effects. Nominal rigidities play an important
role primarily increasing the amplitude of the responses of credit and output variables. These findings
suggest that credit frictions are a plausible amplification mechanism for the impact of financial shocks
and also provide a means for such shocks to impact the labor market in a number of important ways.
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