Heterogeneous Firms, Wages, and the Effects of Financial Crises
Economics Discussion Papers from University of Essex, Department of Economics
The Great Recession manifested itself mostly as a decline in hours and employment in the US, but a decline in Total Factor Productivity in the UK. Why did these two economies experience the crisis differently? I argue that a third fact, that real wages fell further during the crisis in the UK, may provide an explanation. I show that how a financial crisis manifests in the real economy in standard heterogeneous firm models depends crucially on assumptions on wage adjustment, and use this result to explain the divergent experiences of the two countries during the recent financial crisis. Theoretically, while a decline in wages protects the labour market, I show that, in the presence of financial frictions, it also causes a fall in TFP by misallocating resources across firms. Financially unconstrained firms are able to take greater advantage of a decline in wages than constrained firms, leading to a relative reallocation of resources towards the unconstrained, which I show must always reduce TFP in my model. On the other hand, if wages are fully rigid, I show that a financial crisis will have no effect on TFP. Quantitatively, the model is able to explain the greater fall in hours during the crisis in the US, the lack of a significant fall in TFP in the US, and 1/3 of the UK's TFP decline, or "productivity puzzle".
Keywords: financial crises; misallocation; employment; productivity; heterogeneity (search for similar items in EconPapers)
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