Unemployment and Gross Credit Flows in a New Keynesian Framework

The Great Recession of 2008-09 was characterized by high and prolonged unemployment and lack of bank lending. The recession was preceded by a housing crisis that quickly spread to the banking and broader financial sectors. In this paper, we attempt to 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 the model, financial shocks are propagated and amplified through significant variation over the business cycle in the endogenous component of the total factor productivity, the credit inefficiency gap, arising from the existence of search and matching frictions in the credit market. In response to a financial shock, the model economy produces large and persistent increases in credit destruction, declines in credit creation, and overall declines in excess reallocation among banks and firms. The tightening of the credit market results in a sharp rise in the average interest rate spread and the average loan rate. Due to the increase in credit inefficiency that arises from the reduction in firm-bank matches, total factor productivity declines and unemployment increases. Total factor productivity and unemployment take at least 12 quarters to return to baseline. This result is due to a combination of nominal and real frictions. Credit frictions not only amplify the effect of financial shocks by creating variation in the number of firms able to produce due to credit restrictions following a shock - an extensive margin effect - as well as in labor demand by each firm, but they also increase the persistence of the shock's effects. Nominal rigidities play an important role primarily increasing the amplitude of the responses of credit and output variables. These findings suggest that credit frictions are a plausible amplification mechanism for the impact of financial shocks and also provide a means for such shocks to impact the labor market in a number of important ways.