UC Santa Cruz

The Great Recession of 2008-09 in the U.S. was characterized by high and persistent unemployment and lack of bank lending due to liquidity issues. The recession was preceded by a housing crisis that quickly spread to the banking and broader financial sectors.We attempt to account for the depth and persistence of unemployment by considering the relationship between credit and firm hiring explicitly. To do so, we introduce search and matching frictions to characterize the dynamics of credit markets in a series of macroeconomic models that present different types of distortions in the labor market as well as in the interbank market. We obtain a novel propagation and amplification mechanism of a financial crisis associated to an inefficiency wedge that affects the aggregate production function of the economy and depends directly on credit conditions.