We study how financial frictions amplify labor supply shocks in a macroeconomic model with occasionally binding financing constraints. Workers supply labor to entrepreneurs who borrow to purchase factors of production. Borrowing capacity is restricted by the value of capital, generating a pecuniary externality when financing constraints bind. Additionally, there is a distributive externality operating through wages. The planner’s allocation can be decentralized with two instruments: a credit tax/subsidy and a labor tax/subsidy. Labor shocks, such as the COVID-19 shock, amplify the policy responses, which critically depend on whether financing constraints bind or not.
The COVID-19 pandemic has resulted in a complete shutdown of many sectors of the economy with adverse effects for employment and production. The nature of the shock resembles a big drop in labor supply, which has been substantial, but in all hope, temporary. At the same time, such supply shock can adversely affect demand through many channels including the financial sector, and in particular financial frictions can play an important role in amplifying the initial shock. 1 For example, a drop in output due to a laborsupplyshock can weaken