This paper analyses the cyclicality of labour demand and its sensitivity to the cycle in economies characterized by imperfections in capital markets. We show that, in such a case, labour demand depends on firms’ self-financing ability and is affected by changes in the interest rate. Endogenous borrowing constraints affect employment policies by inducing firms to risk averse behaviour, which may reduce their ex-ante willingness to hire. Consistently with recent empirical findings, the model predicts that the more constrained firms are financially fragile, the more the cyclical behaviour of their labour demand is pronounced. This means that, for a given realization of the shock, more leveraged firms adjust their employment level relatively more than more capitalized firms. Furthermore, firms with higher debt to own funds ratios are shown to be more sensitive to the cycle, i.e. to react more to marginal changes in the realization of the shock.
