Financial Intermediary Leverage and Unemployment
Zehao Li, University of Wisconsin-Madison, Ph.D. candidate
I establish that financial intermediary leverage and unemployment are closely related and build a model that combines frictions on financial intermediaries with labor search and matching to explain the relationship. Empirically, in response to a negative productivity shock, unemployment increases substantially when financial intermediary leverage is high, but not in other episodes. The model relies primarily on the stochastic discount factor (SDF) channel. Negative productivity shocks increase the financial intermediary leverage. Because the financial intermediary sector can’t raise enough funds in high leverage states, the SDF increases sharply. Meanwhile, the matching surplus is low. The negative relationship between the SDF and the matching surplus decreases the present value of future matching surpluses. Consequently, vacancy posting and employment plummet in a high leverage state. The model implies that the unemployment rate would have been 2 percentage points lower if the 2008 recession had started with the early 2001 financial intermediary leverage.
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