Lending relationships and labor market dynamics

Motivated by a negative link between credit spreads and labor force participation (LFP) and a positive link between these spreads and unemployment over the business cycle, we study the role of LFP as an amplification mechanism of financial shocks in a labor search model with endogenous LFP, lending relationships, and credit-market disruptions. Amid aggregate productivity and financial shocks that replicate the empirical volatility of LFP and credit spreads, the model produces highly volatile unemployment and vacancies, countercyclical credit spreads and unemployment, and procyclical LFP. When we quantitatively match the cyclical behavior of credit spreads, the interaction between endogenous LFP and financial shocks gives rise to much sharper vacancy fluctuations and plays a key role in generating quantitatively factual cyclical labor market dynamics. (C) 2020 Elsevier B.V. All rights reserved.