Credit Condition, Inflation, and Unemployment; Liang Wang (University of Hawaii at Manoa)

Abstract

We study the effects of the firm's credit condition on labor market performance and the relationship between expected inflation and unemployment in a new monetarist model. Better credit condition has a positive impact on the labor market as firms save on financing cost, improve profitability, and create more vacancies. Inflation affects unemployment through two opposing channels. First, inflation increases the firm's financing cost, which discourages job creation and increases unemployment. Second, inflation lowers wages because unemployed workers carry higher real balances and suffer more from inflation compared to unemployed workers. This encourages job creation. The overall effect of inflation on employment can be positive or negative and depends crucially on the firm's credit condition. We calibrate the model to match U.S. data before the great recession. The calibrated model suggests a small welfare cost of inflation and a downward-sloping Phillips curve with a flexible wage setting. We find that the firm's credit condition is as important as the nominal interest rate to understand the unemployment movement