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.