Macroeconomic dynamics in a model of goods, labor, and credit market frictions

• Goods-market frictions drastically change the dynamics of the labor market.
• Credit- and goods-market imperfections are substitutable in raising volatility.
• Goods-market frictions are however unique in generating persistence.
• Introducing goods market frictions improves the match of models to data.

Goods market frictions drastically change the dynamics of the labor market, both in terms of persistence and volatility. In a model with three imperfect markets – goods, labor, and credit – we find that credit and goods market imperfections are substitutable in raising volatility. Goods market frictions are unique in generating persistence. Two key mechanisms in the goods market generate large hump-shaped responses to productivity shocks: countercyclical goods market tightness and prices alter future profit flows and raise persistence; procyclical search effort of consumers and firms raises amplification. Goods market frictions are thus key in understanding labor market dynamics.