Credit crunches, individual heterogeneity and the labor wedge

Standard neoclassical theory suggests that the marginal product of labor (MPL) should be equal to the marginal rate of substitution between consumption and leisure (MRS). Yet this is not the case in the data. Understanding the measured discrepancy between the MPL and the MRS, commonly referred as the labor wedge, is important to comprehend the limitations of economic models and thereafter improve them. The labor wedge has increased significantly during the Great Recession, but the mechanism of its variation in the credit crunch has not been well understood. This paper fills in this gap by studying the labor wedge in a DSGE model with collateral borrowing constraints. I find that a credit crunch can affect the labor wedge through a mechanism different from that of an exogenous TFP shock when there are endogenous entry and exit of production. With entry and exit, the tightening of the collateral constraints can cause the gap between the real wage and the MRS to increase, but the exogenous TFP shock does not have this mechanism. As a result, the labor wedge has higher increases in the credit crunch. When entry and exit are shut down, the labor wedge would have much smaller increases in the credit crunch.