Lending Relationships and Labor Market Dynamics

Standard models with search frictions in labor markets face limitations in replicating the empirical volatility of unemployment and market tightness in the U.S. In this paper we study the importance of endogenous labor force participation amid credit market disruptions in a labor search model with bank lending relationships. In response to both aggregate productivity and financial shocks that replicate the empirical volatility of labor force participation and volatility and cyclicality of credit spreads, the model produces more than 75 percent of the volatility of unemployment and 90 percent of the volatility of market tightness in the data. The interaction between endogenous participation in labor markets, and long-lasting lending relationships that quantitatively generate the cyclical behavior of credit spreads gives rise to sharper vacancy fluctuations amid financial shocks and plays a key role in replicating the data. In addition, we document a negative link between measures of credit-market distress and labor force participation alongside a positive link between measures of credit-market distress and unemployment. Moreover, we illustrate the policy importance of accounting for labor force participation by analyzing the effects of countercyclical credit subsidies. Only when labor force participation is an endogenous choice does this policy represent an effective stabilization tool.