Financial development, unemployment volatility, and sectoral dynamics

We document a negative and significant relationship between domestic financial development and unemployment volatility in developing and emerging economies (DEMEs) and the absence of such relationship in advanced economies (AEs). A business cycle labor search model with firm heterogeneity, collateral constraints, and interfirm input credit capital can quantitatively rationalize these facts. Greater financial development is associated with lower usage of input credit capital, greater bank credit, and greater capital accumulation, all of which make firms more resilient in the presence of financial shocks. Firms’ increased shock resiliency stabilizes employment decisions, ultimately leading to smoother unemployment fluctuations. Then, by establishing explicit linkages between firms, interfirm input credit acts as an important mechanism that fosters lower volatility across firms under greater financial development. As such, increases in financial development have a smaller impact in stabilizing unemployment in economies with higher average bank credit-GDP ratios and less input credit usage, which is the case of AEs, compared to economies with lower average bank-credit GDP ratios and more input credit usage, which is the case of DEMEs.