Financial Shocks and the Cyclical Behavior of Skilled and Unskilled Unemployment

Abstract

We study the effect of financial shocks in labor market dynamics. We build a model with two types of labor, two types of capital and both search and financial frictions. We find that financial shocks, modeled as exogenous disturbances to the borrowing constraint of firms, can generate realistic movements in aggregate employment and reproduce the volatile and countercyclical ratio of skilled to unskilled employment observed in the data. Tighter financial conditions impact employment through three channels: i) a fall in the marginal product of labor as a result of a reduction in aggregate capital, ii) an increase in the shadow cost of labor in terms of external financing and iii) an endogenous wage rigidity caused by a short-lived increase in households' consumption and in their marginal value of time. This endogenous wage rigidity together with the model’s calibration implying a higher re-hiring probability and lower recruitment costs for unskilled workers, explains the volatility of relative employment.