Interaction of Labour and Credit Market in Growth Regimes: A Theoretical and Empirical Analysis

Earlier research on the links between economic growth and credit market development has abstracted from interactions between labour and financial markets. Moreover, most studies have analysed macro-finance linkages at the aggregate level, ignoring the decentralized nature of search and matching in labour and credit markets. This paper fills this void and thus allows for a more disaggregate analysis of policy effects. We show that the credit market exacerbates and accentuates the labour market effects, having amplifying effects on output, consumption, employment and welfare. Depending on the strength of the debt-dynamics, several growth dynamics emerge from this interaction between labour and credit markets with two distinct steady states: a stable growth regime and another one that is vulnerable and unstable. To test the empirical implications of the theoretical model, a multi-regime VAR (MRVAR) model is fitted to the US output and credit market data. The MRVAR estimation indicates that shocks to credit conditions during a high-growth period have markedly different effects than during a low growth and recessionary period. Also, there are substantial state-dependent asymmetries with respect to the sign of shocks to credit conditions, confirming the theoretical predictions.