DP10596 Financial Risk and Unemployment

Author(s): Zvi Eckstein, Ofer Setty, David Weiss
Publication Date: May 2015
Keyword(s): business cycles, corporate interest rates, equilibrium unemployment, Great Recession, interest rate spread, search and matching models
JEL(s): E22, E24, E32, E44, J41, J63, J64
Programme Areas: International Macroeconomics, Labour Economics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10596

There is a strong correlation between the corporate interest rate (BAA rated), and its spread relative to Treasuries, and the unemployment rate. We model how interest rates and potential default rates impact equilibrium unemployment in a Diamond-Mortesen-Pissarides model. We calibrate the model using US data without targeting business cycle statistics. Volatility in the corporate interest rate can explain about 80% of the volatility of unemployment, vacancies, and market tightness. Simulating the Great Recession shows the model can account for much of the rise in unemployment. Without Fed action, unemployment would have been 6% higher.