Researchers have incorporated labor or credit market frictions in isolation within simple neoclassical models to open up a role for institutions, inject realism into their models and examine the impact of these distortions on output and employment. We present an overlapping generations model with production in which a labor market friction (moral hazard) coexists with a credit market friction (costly state verification). The simultaneous presence and interaction of these two frictions is studied. Our main results are: (i) while credit market frictions affect real activity and employment both in the short and long run, labor market frictions typically have only short-run effects unless they also affect the volume of investment per worker, (ii) the two frictions amplify each other to produce higher long-run unemployment than would result from only labor market frictions, (iii) these distortions have the ability to prolong the effect of temporary shocks, and (iv) the dynamical properties of economies with both frictions are, somewhat surprisingly, qualitatively similar to their frictionless counterparts
