Borrowing constraints, collateral fluctuations, and the labor market

This paper studies the effects of changes in collateral requirements on the cyclical properties of unemployment and job creation. I develop a general equilibrium model in which labor market frictions prevent the costless adjustment of employment. Financial frictions arise from an imperfect enforcement contract. An environment in which borrowing limits are linked to the firm׳s physical capital stock can quantitatively account for the sluggish response of labor market variables to productivity shocks. I find that fluctuations in those variables are mainly driven by changes in financial conditions. The model can explain 75% of the variation in job creation observed in the data, and it can also account for the persistent reduction in both output and leverage that follows a contraction in credit availability.