Unemployment and Gross Credit Flows in a New Keynesian Framework

The Great Recession of 2008-09 was characterized by high and prolonged unemployment and a lack of bank lending. In this paper, we 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 response to a financial shock, the model economy produces large and persistent increases in credit destruction, declines in credit creation, and an overall decline in reallocation of credit among banks and firms; total factor productivity declines and unemployment increases. Credit frictions not only amplify the effect of a financial shock by creating variation in the number of firms able to produce but they also increase the persistence of the shocks effects. These findings suggest that credit frictions combined with nominal rigidities are a plausible amplification mechanism for the impact of financial shocks and provide a mechanism for such shocks to have strong and persistent effects on the labor market.