Debt Constraints and the Labor Wedge

Patrick J. Kehoe, Consultant

Elena Pastorino, Visiting Scholar

May 2016 | American Economic Review, 106(5): 548-553 | With Virgiliu Midrigan
Changes in household debt and employment across regions of the U.S. during the Great Recession are highly correlated: regions where the decrease in household debt was most pronounced were also regions where the decline in employment was most severe. We show that the drop in employment in the regions that have experienced the largest decrease in household debt is mostly accounted for by changes in the labor wedge (deviations from a static consumption-leisure choice) as opposed to changes in real wages. We argue that such a pattern is consistent with fluctuations in debt constraints in a standard Bewley-Aiyagari model.