Welfare Cost of Fluctuations When Labor Market Search Interacts with Financial Frictions

We study the welfare costs of business cycles in a search and matching model with financial frictions à la Kiyotaki & Moore (1997). We investigate the mechanisms thatnallow the model to replicate the volatility on labor and financial markets and show that business cycle costs are sizable. We first demonstrate that the interactions between labor market and financial frictions magnify the impact of shocks via (i) a credit multiplier effect and(ii) an endogenous wage rigidity inherent to financial frictions. Secondly, in a non-linear framework, we show that the large welfare costs of fluctuations are also explained by the high average unemployment and the low job finding rates with respect to their deterministic steady-state values