Liquidity Constraints Faced by Firms and Employment

In this study on labour input and wage formation in Finland the importance of liquidity constraints measured by the ratio of interest payments to cash flow is examined. Financial solvency problems are shown to lead to a reduction in labour input, potentially explaining for the most part the 16% peak rate of unemployment during the deep recession period in the beginning of the 1990s. The link between leverage and “real-side” behaviour of firms is, hence, clear in labour input decisions. The large impact of leverage on employment can be explained by rigid wages and liquidity constraints. Labour hoarding and fixed costs in recruitment increase the long run effects, but also explain the weaker immediate effect as the level of liquidity constraints goes up.