Financial crisis are typically associated with severe economic contractions and, in particular, lasting deteriorations in labor market conditions. Both the Great Depression and the 2007-9 recession are dramatic examples of such phenomena, which seems to be a more general attribute of credit-driven episodes of economic contraction (Reihnart and Rogoff, 2009). Why is this?
Despite such close connection between financial crises and sustained rises in unemployment, there is very little understanding of the mechanisms through which disruptions in credit markets transmit to labor market outcomes. In this blog post, we summarize one such mechanism, developed in Buera, Fattal-Jaef, and Shin (2014), which attempts to fill this gap developing a quantitative model with financial and labor market frictions.