Labour market effects of public strongsectorstrong employment and wages.pdf

Labour market effects of ∗ public sector employment and wages Pedro Gomes† London School of Economics January 29, 2009 Abstract I study the labour market effects of public sector employment and wages. I build a dynamic stochas- tic general equilibrium model with search and matching frictions and both public and private sectors. 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 opposite effects on unemployment. Hiring more people reduces unemployment but increasing their pay raises it. Both shocks increase the wage in the private sector and induce the unemployed to search more for public sector jobs dampening private sector job creation. I then discuss the optimal public 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. 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. The separation rate and the matching elasticity with respect to unemployment are much lower in the public sector than in the private sector. There is also evidence o