Unemployment and Liquidity Constraints * by

We present a dynamic framework for the interaction between borrowing (liquidity) constraints and deviations of actual hours from desired hours, both measured by discrete-valued indicators, and estimate it as a system of dynamic binary and ordered probit models with panel data from the Panel Study of Income Dynamics. We analyze a household’s propensity to be liquidity constrained by means of a dynamic binary probit model. We analyze qualitative aspects of the conditions of employment, namely whether the household head is involuntarily overemployed, voluntarily employed, or involuntarily underemployed or unemployed, by means of a dynamic ordered probit model. We focus on the possible interaction between the two types of constraints. We estimate these models jointly using maximum simulated likelihood, where we allow for individual random effects along with an autoregressive process for the general error term in each equation. A novel feature of our method is that it allows for the random effects to be correlated with regressors in a timeinvariant fashion. Our results provide strong support for the basic theory of constrained behavior and the interaction between liquidity constraints and exogenous constraints on labor supply. ∗Financial support by the National Science Foundation under grants SES-9000200 and SES-9211913 is gratefully acknowledged. Ioannides thanks the John D. and Catherine T. MacArthur Foundation for support through the Research Network on Social Interactions and Economic Disparities. We are grateful to two anonymous referees and the editor, Melvyn Weeks, for generous and very insightful comments that allowed us to improve the paper. We thank Steven Zeldes for kindly making his PSID data available to us for crosschecking against ours, Larry Ball for helpful suggestions with the data, Fumio Hayashi for supplying us with a user-friendly program for reading the PSID data, and Kevin Lee, Steve Nickell, Ariel Pakes, Steven Stern, Jonathan Thomas, and Guglielmo Weber for useful discussions and suggestions. We also thank Steve Bergantino, Raja Chakir, Stelios Corres, Kamhon Kan, Anne Royalty, and Ann-Margret Westin for comments and expert research assistance. We benefitted from comments made during presentations at the 1992 National Science Foundation / National Center for Supercomputing Applications Conference on “Large Scale Computation in Economics” in the University of Illinois, the 1992 ASSET Congress in Toulouse, the University of Uppsala, the University of Guelph, Columbia University, the Congress of the Society for Economic Dynamics and Control in Nafplion, Yale University, VPI&SU, UCLA, LSE, the Department of Applied Economics at Cambridge University, and the Conference on “International Perspectives on the Macroeconomic and Microeconomic Implications of Financing Constraints,” University of Bergamo and CEPR, October 1994. Ioannides thanks the Department of Economics and the Centre for Economic Performance at the London School of Economics for their hospitality during 1994. ∗∗ Department of Economics, London School of Economics, Houghton Street, London WC2A 2AE, UK. vassilis@econ.ac. lse.uk ∗∗∗ Department of Economics, Tufts University, Medford, MA 02155, USA. yannis.ioannides@tufts.edu UNEMPLOYMENT AND LIQUIDITY CONSTRAINTS