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Financial Constraints in Search Equilibrium: Mortensen and Pissarides Meet Holmstrom and Tirole

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  • Tito Boeri
  • Pietro Garibaldi
  • Espen R. Moen

Abstract

The Great Recession has indicated that firms' leverage and access to finance are important for hiring and firing decisions. It is now empirically established that bank lending is correlated to employment losses when credit conditions deteriorate. We provide further evidence of this drawing on a new dataset that we assembled on employment adjustment and financial positions of European firms. Yet, in the Diamond Mortensen Pissarides (DMP) model there is no role for finance. All projects that display positive net present values are realized and financial markets are assumed to be perfect. What if financial markets are not perfect? Does a different access to finance influence the firm's hiring and firing decisions? The paper uses the concept of limited pledgeability proposed by Holmstrom and Tirole to integrate financial imperfections and labor market imperfections. A negative shock wipes out the firm's physical capital and leads to job destruction unless internal liquidity was accumulated by firms. If firms hold liquid assets they may thus protect their search capital, defined as the cost of attracting and hiring workers. The paper explores the trade-off between size and precautionary liquidity holdings in both partial and general equilibrium. We find that if labor market frictions disappear, so does the motive for firms to hold liquidity. This suggests a fundamental complementarity between labor market frictions and holding of liquid assets by firms.

Suggested Citation

  • Tito Boeri & Pietro Garibaldi & Espen R. Moen, 2014. "Financial Constraints in Search Equilibrium: Mortensen and Pissarides Meet Holmstrom and Tirole," CEP Discussion Papers dp1317, Centre for Economic Performance, LSE.
  • Handle: RePEc:cep:cepdps:dp1317
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    References listed on IDEAS

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    More about this item

    Keywords

    search frictions; financial frictions; leverage; liquidity; pledgeability;

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • J64 - Labor and Demographic Economics - - Mobility, Unemployment, Vacancies, and Immigrant Workers - - - Unemployment: Models, Duration, Incidence, and Job Search

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