Debt Constraints and Employment

Abstract:

In the Great Contraction, regions of the United States that experienced the largest change in household debt to income ratios also experienced the largest drops in output and employment. These patterns are difficult to reconcile with standard models of financial frictions. We develop a model with search and matching frictions with on-the-job human capital accumulation that generates such patterns. We calibrate the amount of on-the-job human capital accumulation so that the model reproduces the wage-tenure profiles in the data. We show that with such upward sloping wage profiles, an unanticipated tightening of borrowing constraints leads consumers to discount more the returns to human capital accumulation. Consequently, the match surplus falls and so does the equilibrium number of vacancies firms post. Our key result is that the tightening of consumer borrowing constraints generates a persistent drop in employment and seemingly `sticky’ wages, despite wages being continually negotiated.