To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.jedc.2010.06.016 Byline: Ekkehard Ernst (a), Willi Semmler (b) Abstract: In this paper global macroeconomic dynamics are studied when search frictions are present in both labor and capital markets. On the basis of the macroeconomic model with labor market frictions and capital accumulation, our paper offers an extension to frictions in capital markets, analogously modeled as a search and matching process. Using the Merz model as limit case, we consider exogenous as well as endogenous borrowing constraints. We also allow the cost of issuing bonds to change endogenously. As we show, capital market frictions exacerbate and accentuate the interaction between the two markets and magnify the effects of shocks on output, consumption, employment, and welfare. This interaction of the frictions in labor and capital markets are also shown to give rise to multiple equilibria. On the basis of numerical solution techniques, instead of relying on first or second order approximations around a (unique) steady state, our paper uses dynamic programming techniques to compute decision variables and the value function directly and assess the local and global dynamics of the model. The steady state solutions are studied by using the Hamiltonian and the dynamics are assessed for various model variants by using dynamic programming techniques. Author Affiliation: (a) ILO, International Institute for Labour Studies, Geneva, CH, Switzerland (b) New School for Social Research, Department of Economics, New York, USA Article Note: (footnote) [star] The authors would like to thank participants at the Conference on Computing in Economics and Finance, Paris, 2008, and the 2007 Conference of the Society for Non-linear Dynamics and Econometrics for helpful comments. Many thanks also to Uwe Koller who provided very valuable and timely research assistance as well as to three anonymous referees whose comments helped substantially in improving upon the original version of the paper. An empirical version of this paper was presented at the North American Winter Meeting of the Econometric Society, Atlanta, January 3-5, 2010.