Welfare Cost of Fluctuations When Labor Market Search Interacts with Financial Frictions

Abstract We study the welfare costs of business cycles in a search and matching model with financial frictions. The model replicates the volatility on labor and financial markets. Business cycle costs are sizable. Indeed, the interactions between labor market and financial frictions magnify the impact of shocks via (i) a credit multiplier effect and (ii) an endogenous wage rigidity inherent to financial frictions. In addition, in a nonlinear framework, large welfare costs of fluctuations are explained by the high average unemployment and the low job finding rates with respect to their deterministic steady‐state values.