Wage Commitments, Financial Frictions, and Unemployment

I build a novel model to study how volatility shocks to firm-level productivity affect unemployment through the financial channel of wage commitments. My model can explain 90% of the increase in unemployment during the Great Recession, twice the magnitude in Schaal (2017). The key idea is that wage bills are debt-like commitments by firms to workers, which firms are less likely to take on when volatility is high, so firms hire fewer workers and unemployment increases. The model’s performance in explaining unemployment deteriorates greatly if either financial frictions or volatility shocks are absent. Given the model’s quantitative success, I use it to analyze the impact of the United States and German labor market policies during the recent Covid recession. The U.S. policy raises unemployment benefits, making it more expensive for firms to pay wages, amplifying the recession. Germany subsidizes firms’ wage bills, which also yields a negative impact because the distortion losses outweigh the gains from insuring firms. The losses induced by the two policies are largely underestimated when financial frictions are ignored.