Effects of Credit Supply on Unemployment and Income Inequality

Abstract

The Great Recession, which was preceded by the Financial Crisis, resulted in higher unemployment and income inequality. We propose a simple model where firms producing varieties face labor-market frictions and credit constraints. In the model, tighter credit leads to lower output, a lower number of vacancies, and higher directed-search unemployment. If workers are more productive at higher levels of firm output, then a lower credit supply increases firm capital intensity, raises income inequality by increasing the rental of capital relative to the wage, and has an ambiguous effect on welfare. With an initially high share of labor costs in total production costs, tighter credit lowers welfare. This pattern reverses during an expansionary phase when there is higher credit availability.