Coauthored with Dr.David Florian Hoyle, who works as a research economist at Central Bank of Peru this paper attempts to explain the depth and persistence of unemployment by considering the relationship between credit and firm hiring explicitly. Starting with a simple vector autoregression framework and historical data on gross credit flows in the U.S. economy the paper examines the effects of financial shocks on credit and unemployment. Interestingly financial shocks generate a strong and attenuated response in unemployment. The authors develop a New Keynesian model with nominal rigidities in wages and prices, and introduce a banking sector characterized by search and matching frictions with endogenous credit destruction.
Financial shocks are propagated and amplified through significant variation over the business cycle in the endogenous component of the total factor productivity (credit inefficiency gap) arising from search and matching frictions. This model predicts a deep and sustained recession with a substantial increase in unemployment that lasts for at least 12 quarters and reproduce the conditional responses of labor productivity, inflation, and gross credit flows to a financial shock for the U.S. economy as well.