Aggregate implications of financial and labour market frictions

This paper develops a model with both financial and labor market frictions, and jointly analyzes the precautionary behavior of firms and households. Financial frictions generate costly bankruptcy risk for firms and limited insurance against unemployment risk for workers. We solve and simulate a calibrated version of the model and show that the precautionary decisions of households and firms interact with each other to significantly amplify the effect of financial factors on aggregate output and unemployment, even in the absence of price and wage rigidity. This result can be interpreted as a negative demand externality. Firms fire workers to maximize profits, but do not internalize the negative effect of the increase in unemployment on households. Households consume less to increase precautionary saving, but do not internalize the negative impact of their decision on firms' profits and default risk. The importance of this externality is quantitatively large. We calibrate an economy with moderate default risk in firms and a very small risk aversion and precautionary behavior of households, obtaining an equilibrium unemployment level of 6.5%. Increasing risk aversion to more realistic levels increases equilibrium unemployment up to 11.1%. The same increase in risk aversion applied to an economy with more severe firm financing frictions increases unemployment from 7.7% to 21.6%. Finally, we conduct policy experiments and analyze to what extent firing costs and unemployment benefits reduce the impact of this negative externality.