Lending Relationships and Labor Market Dynamics

Standard labor search models face limitations in replicating the empirical volatility of unemployment and market tightness. We document a positive link between measures of credit-market distress and unemployment, and a negative link between measures of credit-market distress and labor force participation. We introduce monopolistic competition and persistent lending relationships in the banking system into an RBC search model with endogenous labor force participation. Amid aggregate productivity and financial shocks that replicate the empirical volatility of labor force participation and credit spreads, the model can replicate close to 90 percent of the volatility of unemployment and virtually all of the volatility in market tightness in the data. The interaction between endogenous participation in labor markets and long-lasting lending relationships plays a key role by providing a powerful amplification mechanism of financial shocks. We illustrate the policy relevance of accounting for labor force participation by analyzing the impact of countercyclical unemployment benefits and interest rate subsidies. We find that both are effective stabilization interventions.