Propagation in a Model of Goods, Labor and Financial Market Frictions

Investigating mechanisms of propagation has been central to the business cycle research agenda since its inception. Recent search models of the labor market fail in generating both the size and the persistence of their of central variables to productivity shocks, as does the RBC model in the case of output. Building a model with three imperfect markets - goods, labor and credit -, we find that goods market frictions drastically change the qualitative and quantitative dynamics of labor market variables, leading to significant improvements in bridging the gap with the data both in terms of persistence and volatility. Two factors affecting the expected path of the value to hiring a worker generate persistence: first, the expected dynamics of congestion on goods market, which depends on consumers' search for goods and the entry of new products; and second, the expected dynamics of prices, which alter future profit flows. In the absence of these frictions, there is no persistence in the growth rates, and little amplification, of labor market variables.