The high sensitivity of employment to agency costs: The relevance of wage rigidity

•I model the interaction between financing constraints and labor market imperfections.•I study the role this interaction plays in labor market dynamics.•With Nash wages a productivity shock hardly changes cyclical labor market dynamics.•With rigid wages a financial accelerator induces realistic labor market volatilities.

The paper studies the interaction between financing constraints and labor market imperfections and the role of this interaction on labor market dynamics. In the model economy, a positive productivity shock is amplified through endogenous fluctuations in the financial market. The paper shows that if wages are set via Nash bargaining, the productivity shock substantially increases wage volatility and, as a result, the shock has very little effect on firm profitability and hiring workers over the business cycle. When the model includes wage rigidities, however, firms’ profitability becomes highly responsive to productivity changes: the financial accelerator mechanism induces additional fluctuations in labor market quantities, as observed in the data.