Labour market effects of public sector employment and wages

Pedro Gomes

No 313, 2009 Meeting Papers from Society for Economic Dynamics

Abstract: I build a dynamic stochastic general equilibrium model with search and matching frictions and both public and private sectors, in order to study the labour market effects of public sector employment and wages. I discuss what is the public sector wage that achieves the social planner's solution and how it varies with different labour market parameters. Public sector wage and employment shocks have mixed effects on unemployment. A wage shock raises unemployment rate while a reduction in the separations reduces it. Hiring more people can increase or decrease unemployment depending on the level of wages. All shocks increase the wage and crowd out employment in the private sector because they induce more unemployed to search for public sector jobs. I then discuss the optimal policy in response to technology shocks. It consists on a counter-cyclical vacancies posting and a procyclical public sector wage. Deviations from the optimal policy can increase the volatility of unemployment rate significantly. In the empirical part, I start by reviewing the micro evidence on public sector wages and the endogeneity of the sector choice. Then, I employ Bayesian techniques to estimate the parameters of the model for the US, using quarterly data on government employment and wages, unemployment rate, private sector wages, job separation rate and job finding rate. I find evidence that the direct search mechanism plays a role over the business cycle and that public sector vacancies are mildly counter-cyclical while public sector wages are acyclical. To complete the empirical study, I estimate a structural VAR model. I find that public sector employment and wages positively affect private sector wage. The negative effect on private sector hours is only significant over the last 20 years. Both government employment and wages do not respond to innovations in productivity.

Date: 2009
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