The Interaction between Household and Firm Dynamics and the Amplification of Financial Shocks


Empirical studies examining the 2007-2009 Great Recession suggest that financial shocks to households and firms are both important to explain output and employment fluctuations. Motivated by this evidence, we develop a model with financial and labor market frictions in which heterogeneous households face unemployment risk, and heterogeneous firms face costly bankruptcy and finance themselves partly with nominally fixed long-term debt. We show that shocks that cause household deleveraging and credit shocks to firms interact to greatly amplify the effects of financial shocks on output and employment, even when these same shocks separately have moderate effects.