Labor Market Representation in Quantitative Macroeconomic Models for Developing Countries
An Application to Cote D'Ivoire
  • 1, International Monetary Fund

This paper presents a quantitative macroeconomic model that accounts for key features of the labor market in developing countries. Primarily inspired by Côte d’Ivoire, the model contrasts a formal urban sector, where wages are rigidly fixed and employment is submitted to firms profit-seeking behavior, to urban and rural informal sectors, where wages are flexible and employment is affected by fluctuations in formal sector employment. Dynamic simulations assess the impact on key macroeconomic variables of a terms of trade improvement, a public wage decrease, and an exchange rate adjustment, highlighting the roles of rural-urban migrations and capital accumulation in the informal urban sector.


This paper presents a quantitative macroeconomic model that accounts for key features of the labor market in developing countries. Primarily inspired by Côte d’Ivoire, the model contrasts a formal urban sector, where wages are rigidly fixed and employment is submitted to firms profit-seeking behavior, to urban and rural informal sectors, where wages are flexible and employment is affected by fluctuations in formal sector employment. Dynamic simulations assess the impact on key macroeconomic variables of a terms of trade improvement, a public wage decrease, and an exchange rate adjustment, highlighting the roles of rural-urban migrations and capital accumulation in the informal urban sector.

I. Introduction

Existing quantitative macroeconomic models of developing countries are essentially of two types: the Mundell-Fleming framework, which assumes a complete specialization in production, 2/ and the “dependent economy” model, which subdivides the production structure into a nontradable sector whose production is consumed locally and a traded sector that produces a single good consumed both at home and abroad. 3/ Both models consider a single labor market with a homogeneous labor force and assume that wages either clear the labor market or are partially indexed to prices, thus inducing unemployment. In addition, the tradable-nontradable model assumes that the labor force is perfectly mobile among sectors, which implies that wages equalize across sectors. For reasons of simplicity or data limitations, these models rarely take into account key features of labor and good markets in many developing countries like Côte d’Ivoire. In particular, these models ignore key dualisms in both labor and goods markets. First, the labor market is not homogeneous but instead opposes fundamentally employees of the formal sector to self-employed and family aides of the informal sector. In particular, the formal sector is characterized by more institutionalized wage setting mechanisms, while market-clearing mechanisms are more likely in the informal sector, where open unemployment is rarely observed. Second, the tradable sector is not specialized in production and technology, but instead groups together modern highly productive industries on the one hand, and agricultural activities of small farm units producing traditional exportable goods with low productivity, on the other hand. To the extent that these dualisms are central to the adjustment of developing economies, they may seriously challenge the simulation properties of both the Mundell-Fleming and the “dependent economy” models.

The approach followed here assumes that dualisms affecting employment, production, and wage determination in many developing countries can be captured by considering that the economy is divided into three sectors: the rural sector, the urban formal sector, and the urban informal sector. 4/ The rural sector is composed to a large extent of self-employed persons and unpaid family members. Capital is scarce whereas labor is abundant, which implies that the sector features low levels of labor productivity and incomes. Because of limited production diversification, agriculture revenues are highly sensitive to climatic changes and international commodity market fluctuations, as well as agriculture price policy decisions. Adverse shocks to agriculture revenues contribute in turn to migration flows to urban areas. The formal urban sector consists essentially of medium- and large-scale enterprises producing mainly industrial goods using skilled and unskilled labor. In this sector, workers are hired through formal contracts, wage settlements are subject to labor regulations, and wages are negotiated through collective bargaining mechanisms. Public employment is considerable and wage increases initiated in the public sector are largely transmitted to the private sector, especially in sub-Saharan African countries. By contrast, the informal sector consists essentially of self-employed individuals and small, family-based enterprises. There are no labor regulations and trade unions. Remunerations are highly flexible and are affected by overall labor market conditions, in particular labor migrations from the rural sector and the formal urban sector.

The purpose of the present paper, primarily inspired by the case of Côte d’Ivoire, is to develop and analyze a quantitative macroeconomic model that accounts for these sectoral breakdowns of both goods and labor markets in the modeling of developing countries. The model is intended to be suitable for the analysis of policy recommendations and the simulation of alternative macroeconomic scenarios. The primary concern of our analysis is to examine the implications of this alternative modeling for the dynamic adjustment of employment, production, and other key macroeconomic variables to standard macroeconomic shocks. We shall explore the dynamic effects of three types of shocks: an improvement in the terms of trade, a reduction in public wages, and a devaluation of the domestic currency. Database and parameter estimates have been drawn from Côte d’Ivoire’s case at the end of the 1980s to implement these simulation shocks.

The remainder of this paper is organized as follows: Section II provides a short description of the labor market in Côte d’Ivoire. The quantitative macroeconomic model is developed in Section III, and the construction of the base-year data base and the key parameters of the model are discussed in Section IV. Dynamic simulations of the model are performed in Section V. Conclusions are presented in Section VI.

II. The Labor Market in Côte d’Ivoire 5/

Table 1 presents some basic data on the population and labor force in Côte d’Ivoire over the period 1980-92. We assume that open unemployment is nonexistent, although official estimates of unemployment are published by the Ivoirien authorities. 6/ Given the lack of unemployment benefits, it is likely, however, that most of these reported unemployed workers have some minor activity in the informal sector. For that reason, these people are reported in Table 1 as workers in the informal urban sector, although it is likely that this sector comprises massive underemployment. 7/

Table 1.

Cote d’Ivoire: Population and employment, 1980–92

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Source: See Section IV below.

It appears from Table 1 that a substantial part of the economically active population is employed in the agricultural and the informal urban sectors, while the share of the labor force employed in the modern urban sector remains very limited. For example, our estimates indicate that in 1992, only 6 percent of the labor force was employed in the modern urban sector, both private and public. The data reported in Table 1 also indicate that between 1980 and 1992, the Ivoirien economy underwent major shifts in the sectoral allocation of labor. The large increase in the economically active population over the 1980s was absorbed by the informal sector to a large extent and the agricultural sector to a lesser extent, while employment in the modern sector steadily decreased over time. It follows that in proportion to the total labor force, employment in the agricultural sector and the modern urban sector was reduced, whereas the size of the informal sector substantially increased. Table 1 also shows that over the period considered, the growth rate of the urban population exceeds the growth rate of the total population and is at least five times higher than the growth rate of the rural population. This large rural-urban gap in population growth suggests that the strong increase in urban population is due to a large extent to massive rural-urban migration flows. As the access to the modern urban sector is rather limited, it is likely that most of these migrants ended up in the informal urban sector.

Table 2 presents data on the level and the composition of the gross domestic product by sectors over the period 1987-91. It appears from this table that between 1987 and 1991, the overall economic activity grew by only 3 percent. Undoubtedly, this growth rate was insufficient to keep up with the strong growth of the labor force which, as indicated in Table 1, grew by more than 15 percent over the same period. On a sectoral basis, the data reported in Tables 1 and 2 indicate that the growth rate of agricultural production largely exceeded the growth rate of agricultural employment, which suggests that this sector experienced a considerable improvement in labor productivity. Conversely, one can observe that in the informal sector, the sizable increase in the labor force has been associated with a drop of production. This result is probably due to an underestimation of production in the informal urban sector. It seems to indicate though, that there is a substantial excess of labor in this sector and, accordingly, a large part of the labor force is underemployed. It is therefore appropriate to assume that in this sector, the marginal productivity of labor is low.

Table 2.

Côte d’Ivoire: Gross Domestic Product and Sectoral Value Added, 1987–91

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Source: See Section IV below.

Rough estimates of nominal wages in each sector of activity are reported in Table 3. 8/ These estimates first suggest that there exists a sizable and rather stable spread between the agricultural wage rate and the average wage rate in urban areas. One can suspect that this wage differential motivated many rural workers to migrate toward cities, even if the probability of securing a highly paid job in the urban sector was rather small. 9/ These estimates also suggest that within the urban sector, the wage rate paid to workers in the formal private sector is about four times higher than the wage rate received by informal workers. This formal- informal wage differential can be related, not only to the significant differences in the productivity and skills between the two classes of workers, as measured by the average nominal value added per worker, but also to the influence of trade unions and formal wage setting procedures. Finally, one can observe a continuous decline of wages in the informal sector.

Table 3.

Côte d’Ivoire: Sectoral Wages, 1987–91 1/

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Source: See Section IV below.

The nominal wage in the agricultural and urban informal sectors is measured by the average product. The nominal wage rate paid to civil servants is calculated by the ratio of the value added by the public administration to public employment. Finally, the wage rate paid to workers in the urban formal sector is measured by the unit labor cost under the assumption that 50 percent of the value added in this sector consists of labor costs. Some evidence on the allocation of value added between profits and wages in the modern private sector is provided by Kanbur (1990).

This brief overview makes it clear that in Côte d’Ivoire, as well as in other African countries, the sectoral composition of employment, and not just its level, does matter. The analysis developed in the following sections focuses on this issue. In particular, it investigates how and to what extent the sectoral allocation of labor is affected by some domestic and external disturbances of the type encountered by most developing countries.

III. The Model

This section describes a dynamic model of a small, open developing country with a fixed exchange rate. The economy is composed of three sectors of production: the agricultural sector, the urban formal sector, and the urban informal sector. The agricultural sector produces two goods. One good is exported while the other one is not. In what follows, the first type of goods is referred to as agricultural exports while the second type of goods is referred to as agricultural food crops. Production in the urban formal sector consists essentially of manufactured goods, which are sold in both the international and domestic markets. Conversely, the output of the urban informal sector consists only of nontraded goods, that is, domestic services, handicrafts, or petty trade. As domestic services account for a large part of the output in the informal sector, the production of this sector will be referred to as nontraded services. The imports of the country comprise only manufactured goods, which are imperfect substitutes for the goods produced by the modern urban sector. 10/

The total labor force is allocated among five activities: the production of agricultural food crops, the production of agricultural exports, the production of manufactured goods, the production of nontraded services, and the production of public goods. Workers in the agricultural sector are assumed to consist only of self-employed persons and nonpaid family aides whose income is equal to the average agricultural product. They are assumed to allocate their time between the two agricultural activities according to the profitability of each activity. In the urban modern sector, wages are indexed to public wages whereas the amount of labor employed is determined according to the profit maximizing behavior of producers. Public employment and wages are both set exogenously. Finally, labor in the informal sector consists of all of those workers who failed to secure a job in the urban formal sector. Informal workers are all considered to be self-employed persons. Their wage rate is equal to the average product and is therefore perfectly flexible. The model also allows for rural-urban migrations. It is assumed that the decision to migrate depends on the wage differential between the rural sector and the urban private sector.

On the demand side, the model assumes that households allocate their disposable income between agricultural food crops, manufactured goods, whether imported or produced domestically, and the nontraded services provided by the informal sector. The model includes public and private investment. Private investment takes place only in the urban modern sector. Investment goods are assumed to consist only of manufactured goods, whether imported or produced domestically.

Finally, the model assumes Walrasian equilibrium in every domestic commodity market. The economy is assumed to be a price taker in the market for its exports of agricultural and manufactured goods and the market for its imports of manufactured goods. 11/

1. Labor, migrations, and wage determination

This section describes how employment and wages are determined in the different sectors of the economy.

a. The agricultural sector

It is assumed that rural households are self-producers who produce two types of goods: agricultural food crops (paddy, maize, cassava, etc.) and agricultural exports (cocoa, coffee, etc.). The production of each good combines two factors of production: labor and intermediate inputs. Labor and intermediate inputs are treated as complementary. For each good, the available technology is then described by a production function relating labor to value added: 12/


where V(i) denotes the value added of sector i at constant prices, L(i) denotes the labor force employed by sector i, A is an efficiency parameter, β is the elasticity of output to labor, and the term exp[γ(i)t] allows for technical progress in sector i.

Open rural unemployment is assumed to be nonexistent, which implies that the sum of workers employed in the two agricultural sectors must equal the initial endowment of rural workers:


where Lr denotes the rural labor force available at the beginning of the current period.

Rural households allocate labor among the two productions so as to maximize their revenue, given the price of the two goods and the available technology. Formally, we have:


subject to (1) and (2),

where PV(i) is the price index of value added in sector i.

From the first-order conditions for profit maximization, we find that the demand for labor in each sector is determined according to the following relationship:


where β0 = log(A2/A1).

Substituting (2) into (3) and solving the resulting equation under the assumption that β1= β2= β determines the demand for labor in the A-F sector: 13/


where α=1/(β-1) <0 and λ0=β0*σ/2.

Because of adjustment costs, labor is assumed to adjust only partially to its desired level. Assuming a simple adjustment scheme, we ascertain that the actual level of employment in the A-F sector is given by:


where δ1 is a parameter describing the speed of adjustment, L1(-1) denotes the labor force employed in the A-F sector at the beginning of the previous period, and L1d is given by expression (4).

Over time, the quantity of labor available in the rural area is affected by population growth and migration flows between the rural and urban areas. Following the approach of Harris and Todaro (1970), we assume that rural-urban migration is determined by the differential between rural and urban wages. 14/ To account for the relatively limited opportunities of employment in the public sector, only the urban private wage is considered, and thus we have: 15/


where Mig denotes rural-urban migration flows of the labor force over the current period, Wu is the nominal wage rate in the urban private sector, and Wr is the agricultural wage rate.

The urban private wage rate is defined as:


where W3 and W4 denote the nominal wage rate in the formal and informal sectors, respectively, and L3 and L4 denote the labor force employed in each sector.

The agricultural wage rate is set equal to the average agricultural product:


which implies that the agricultural wage rate responds to any changes in the average productivity of each sector, the relative price between the two agricultural goods, and the distribution of the rural labor force among the two sectors.

Finally, the rural labor force is determined by:


where Lr(-1) is the rural labor force at the beginning of the previous period and λr denotes the biological growth rate of the rural labor force.

b. The formal urban sector

The formal urban sector produces one manufactured good that is sold both domestically and internationally. Production is obtained by combining three factors: capital (K3), labor (L3), and intermediate inputs (N3). Capital and labor are assumed to be perfect substitutes, while intermediate inputs are treated as complementary to value added. We assume that the technology is described by a CES production function in capital and labor:


where A3 is an “efficiency” parameter, θ3 is a distribution parameter related to the share in each factor in total factor costs, and ρ3 is the substitution parameter.

From profit maximization, we can express the demand for labor as follows: 16/


where σ3=1/(1+ρ3) is the elasticity of substitution between capital and labor.

Labor is assumed to adjust partially to its desired level. As before, we assume a simple partial adjustment scheme, and thus we have:


where L3d is given by the expression (11).

Finally, wages are assumed to be fixed by institutional factors, which, in particular, provide for a full indexation to public wages:


where λg denotes the growth rate of public wages.

c. The informal urban sector

The modeling of employment in the informal urban sector is based on the assumption that the informal urban sector absorbs all workers released from the other urban sectors. 17/ Accordingly, the quantity of labor available in the informal urban sector is given by:


where Lu denotes the urban labor force and is assumed to grow over time at a constant biological growth rate λu:


For simplicity, we shall assume that λu = λr.

Under the assumption that the capital-labor ratio is very low in the informal sector, the production technology can be described by:


As already noted, the informal sector consists essentially of self-employed individuals whose revenues can be approximated by the output of their production activities. The nominal wage rate of these individuals is therefore expressed as:


According to this formulation, changes in the wage rate reflect changes in the price of informal goods as well as changes in the average productivity of labor.

d. The public sector

The real value added of public administrations is approximated here by their total wage bill at constant prices, namely:


where Lg denotes the exogenously given public employment, Wg the wage rate paid to civil servants, and the o superscript indicates base-year values.

Public wages are determined according to:


where λg is set exogenously.

2. Output and demand for intermediate inputs

As we assumed that intermediate inputs are complementary to the other factors of production, the production and the demand for intermediate inputs by each private sector are determined according to the following relationships:


where α(i) denotes the base-year share of intermediate inputs in the total production of sector i.

The total purchase of intermediate goods by the public administrations is treated as exogenous:


From expressions (21) and (22), the total demand of intermediate goods addressed to each private sector is simply:


where the α(i, j) are input-output coefficients. The coefficients are constant.

3. Aggregate demand

Real aggregate demand for domestic output is the sum of private consumption, private and public investment, government expenditures, and the trade balance. In this section, we discuss how these different components of aggregate demand are determined.

a. Private consumption

Private consumption is modeled as a function of the real disposable income and the domestic inflation rate with a partial adjustment mechanism:


where CP denotes the aggregate private consumption, YD denotes the household disposable income, and PC is the domestic consumer price index. The current inflation rate is introduced so as to account for real cash balance effects.

Private consumption is allocated to three types of goods: agricultural food crops, manufactured goods, whether produced domestically or imported, and services provided by the informal sector. The consumption of each individual good is determined according to:


with the constraint that C1+C3+C4=CP. The variables PCi denote the domestic currency price index of each good i, the variables εci denote the elasticities of the consumption of each individual good to aggregate consumption, the variables εi are the respective price elasticities of consumption, and the variables ci are constants.

b. Investment

As already mentioned, only private investment in the modern industrial sector is explicitly modeled. Furthermore, we assume for simplicity that investment goods consist only of modern industrial goods, whether domestically produced or imported from abroad. The specification of the private investment function is based on a simple accelerator mechanism. It relates private investment, Ip, to changes in output. 18/ Under the assumption that the capital stock adjusts slowly to its desired level, we establish that Ip is determined according to:


where κ0 is a constant, κ1 is the capital-output ratio, κ2 is the adjustment speed of capital to its desired level, and dep is the depreciation rate of capital.

The stock of private capital at the beginning of the current period is given by:


where Kp(-1) denotes the stock of capital inherited from the previous period.

Aggregate investment is the sum of public investment and private investment. Assuming that public investment is exogenous, we have:


c. Public consumption

Public consumption is equal to the production of public administrations, which in turn is the sum of the public sector output (Vg) and the government purchases of intermediate goods (Ng):


d. Trade balance

Total exports are the sum of agricultural exports and exports of manufactured goods produced in the modern formal sector. Exports of raw agricultural goods are computed as the production of agricultural exports minus the domestic demand for these products, assumed to be limited to intermediate consumption:


where CI2 denotes the demand for intermediate goods addressed to sector 2 by the other sectors.

Reflecting profitability motivations of producers, the share of exports in the total production of the modern industrial sector is modeled as a function of the relative prices of manufactured goods in the domestic and international markets. As it is largely recognized that there are time lags before changes in relative prices exert their influence on the volume of exports, a partial adjustment scheme is also introduced. Formally we have:


where E is the fixed nominal exchange rate index and IP3 is the international price index of manufactured goods. 19/

As stressed previously, imports consist only of modern industrial goods, supposedly imperfect substitutes to locally produced goods. Therefore, the share of imports in the domestic absorption of industrial goods is derived as a function of relative prices. Again, to capture dynamic price impacts, the specification of the import function includes a lagged import term. Formally, we have:


where M3 represents the volume of imports, QD3 denotes the domestic absorption of industrial goods, CI3 is the demand of intermediate goods addressed to the modern industrial sector, PD3 is the price index of domestic absorption, and PM is the domestic currency price index of imports. 20/

4. Commodity market equilibrium and prices

This section describes how market equilibrium and output prices are determined.

Our model assumes that the markets for agricultural food crops, locally produced industrial goods, and informal goods are characterized by Walrasian equilibrium, which implies that in each market, output prices adjusts automatically and instantaneously so as to clear the market at any time:


where CI(i) denotes the total demand for intermediate goods addressed to the sector i. The solution to (36), (37) and (38) gives the output prices P1, P3 and P4.

The domestic output price of agricultural exports is related to the exogenously given international price according to:


where IP2 is the international price index of agricultural exports and TE is an export tax index.

Similarly, the domestic currency price index of imported goods is given by:


where TM is an import tax index.

5. Other macroeconomic identities

The gross domestic product can be computed both by origin(a) and by expenditures(b):


Household disposable income is computed as the sum of the value added of the agriculture sector and the informal sector, plus the wage bill of the formal sector and public administrations minus taxes on agricultural exports and taxes on wages:


where td denotes the direct tax rate, measured as the ratio of current taxes on wages and social security contributions to wages and π is an exogenous term representing the other sources of revenues (i.e., government and international transfers and net property income).

The financial part of the model is standard. It includes the modeling of the financial account of each sector, the modeling of the balance of payments and the money market equilibrium, as well as the modeling of the government balance. As one essential feature of the model is that financial variables do not affect the behavior of real variables, the financial part of the model is not presented here. This dichotomy between the real and financial sectors of the economy enables us to focus on the real effects of alternative types of shocks.

IV. Data Construction and Parameter Estimation

The database of the model is derived in part from the data published by the Ivoirien statistical services. However, as the sectoral classification developed here is not directly available, these data had to be transformed. The section discusses briefly the major issues involved in the database construction. For reasons of data availability, 1988 was chosen as the base year. This section also provides a short discussion of the parameters imposed on the model.

1. Construction of base-year data

Basic data on production are drawn from the last available issue of the national accounts published by the Ivoirien statistical institute (INS, 1993). This statistical issue covers the period from 1987 to 1991 and contains both aggregate data on production, value added, and intermediate consumption, as well as sectoral data on value added. The sectoral classification covers 33 sectors. The transition from this sectoral classification to the classification outlined in the model is shown in Appendix II, Table 1.

The construction of the agricultural food crop sector and the agricultural export sector is rather straightforward. Conversely, the composition of nonagricultural activities into the formal and informal sectors is reconstructed, using in some cases arbitrary keys. According to our classification, the informal sector is composed essentially of retail trade and services other than banking, insurance, and public services. However, as reported by several studies on African countries [see, for example, DIAL (1993)], the informal sector is not limited to retail trade and services but also includes a sizable share of industrial activities, such as construction, textiles, and agro-industry. To account for this element, we added to the informal sector 50 percent of the activities of the following branches: other foodstuffs, textiles, construction, and transports, as well as 15 percent of the activity of the wood industry. 21/ Table 4 presents the repartition of the domestic value added between the five sectors considered. It appears that the contributions of the agricultural food crop sector, the agricultural export sector, the formal urban sector, the informal urban sector and the government sector to aggregate value added are, respectively, on average over the period 1987-91, equal to 18.4, 16.8, 30.5, 22.5, and 12.0 percent.

Table 4.

Côte d’Ivoire: Sectoral Value Added

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A-F = agricultural foodcrops, A-E - agricultural exports, U-M - urban formal sector, U-S – urban informal sector, G - public administration.

Sectoral data on production are available from the 1987 input-output matrix. This series is extended to 1988 on the basis of the INS industrial production index and the agricultural production index calculated by the Ministry of Agriculture. The conversion into our sectoral classification is performed using the methodology described above. For each branch, total intermediate consumption is calculated as the difference between production and value added and split among the different goods on the basis of the 1987 input-output coefficients.

Basic data on population are taken from the recent statistical profile on Côte d’Ivoire issued by the World Bank (1994). Total economically active population at the base-year (1988) is then obtained by multiplying the total population by the 1986 ratio of economically active population over total population. This ratio is taken from the most recent Enquête Permanente auprès des Ménages issued by the Ministère du Plan (1988). Its value is 0.466. The allocation of the total labor force among the different sectors is obtained as follows. Data on employment in the formal urban sector, the public administrations and the agricultural sector are drawn directly from the World Bank statistical profile on Côte d’Ivoire. The rural labor force is split among the agricultural food crop and export sectors using the information provided by Kanbur (1990) on the distribution of households according to the employment status of the head of households. Employment in the informal urban sector is computed as a residual. Following this methodology, we established the sectoral distribution of employment of the economically active population in 1988: agricultural food crop sector, 36 percent; agricultural export sector, 19 percent; formal urban sector, 5 percent; informal urban sector, 37 percent; and public sector, 3 percent.

Aggregate and sectoral data on capital are not available. A rough estimate of the capital stock in the modern private sector was obtained by assuming a capital-output ratio equal to 2.

Finally, basic data on the composition of aggregate demand are taken from (INS, 1993), while the balance of payments, public finance, and monetary data are based on IMF staff estimates. Base-year key structural characteristics of the Ivoirien economy are reported in Table 5.

Table 5.

Côte d’Ivoire; Structural Characteristics and Key Parameters

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2. Parameters

The parameters imposed on the model to generate the baseline data and run the simulations are reported in Table 5. Owing to lack of econometric evidence on Côte d’Ivoire, the values of the parameters are either set arbitrarily or drawn from developing country estimates in the literature.

In the agricultural sector, the elasticity of production to labor is set at 0.6, which gives a long-run elasticity of output with respect to relative prices of -0.75. 22/ The speed at which rural labor is reallocated from one sector to the other is assumed to be slow and is given a value of 0.25 (which corresponds to a mean lag of three years). In the urban informal sector, the elasticity of production to labor is assumed to be low --0.40--owing to the existence of massive underemployment. As far as the modern industrial sector is concerned, the elasticity of substitution between labor and capital is assumed to be 0.8, which is close to most empirical estimates for industrial and developing countries. The distribution parameter θ of the CES production function is computed on the basis of base-year data, while the speed at which labor adjusts to its desired level is set equal to 0.40 (reflecting a mean lag of 1.5 years). Finally, the input-output coefficients are drawn from the 1987 INS input-output matrix as transformed to conform to our sectoral classification.

The short-term income elasticity of private consumption is set equal to 0.6. With the adjustment parameter set equal to 0.6, we then obtain a long-run income elasticity of 1.0. The elasticity of consumption with respect to current inflation is assumed to be -0.20, which is consistent with various empirical estimates. The parameters imposed on the individual consumption functions are based on the assumption that agricultural food crops are mainly subsistence goods whose consumption is quite stable and thus less sensitive to changes in aggregate consumption and relative prices than the consumption of goods produced by the urban formal and informal sectors.

In the case of the export supply and import demand functions, the long-run elasticities with respect to relative prices are set at 0.8 in absolute value, which is in the range of values reported by several empirical studies. 23/ The adjustment parameter is set at 0.50 in both functions, thereby providing a mean lag of one year which is in conformity with the empirical literature.

In the case of the investment function, the capital - output ratio is set at 2.00, the speed of adjustment of capital to its desired level is assumed to be 0.25, and the rate at which the stock of capital depreciates over time is given a value of 0.05.

Finally, we assign a value of 0.1 to the sensitivity of rural-urban migration flows to rural-urban wage differentials. 24/

V. Dynamic Simulations

The main properties of the model are investigated by simulating three standard shocks, adopted here for purely illustrative purposes. The first shock is an exogenous improvement in Côte d’Ivoire’s terms of trade, attributable to an increase in its average agricultural export price expressed in CFA franc terms. The two other shocks are policy oriented, stylizing two different adjustment strategies, one purely domestic, with a reduction of public wages, the other purely external, with a devaluation of the CFA franc. The dynamic effects of these shocks are examined over a period of four consecutive years, starting in 1988, by comparing the results of the simulations with a baseline scenario, 25/ The magnitudes of the three shocks are set as a 20 percent permanent change in the absolute level of the corresponding exogenous variables over the four-year simulation period. It should be noted when analyzing the simulation results that, as real interest rates play no role in determining real variables in the present version of the model, simulations implicitly integrate a non-accommodating monetary policy rule indexing nominal interest rates to Inflation.

The simulations provide some expected results while offering some new insights. For example, the devaluation exercise produces some new elements to the classical debate regarding the pros and cons of the currency devaluation as a means of obtaining GDP growth effects, 26/ In addition, our results widen standard interpretations by pointing out sectoral effects, notably the role of the urban informal sector. The terms of trade simulation exhibits some features of the Dutch disease: a strong positive impact on the external balance, a more limited impact on real GDP, and resilient inflation pressures during the four years leading to a substantial appreciation of the real exchange rate. 27/ The wage and devaluation simulations have both positive and increasing impacts on GDP, improving both external and fiscal balances. The wage simulation reduces prices steadily, while the devaluation increased them, reducing almost entirely the initial reduction of the real exchange rate. Consequences to be drawn from the latter result could be crucial in the design of adjustment policies: the control of inflation through wage policies in the formal sector–which implicitly assumes a model with exogenous wages–should be enlarged to the informal sector in order to dispose of efficient anti-inflation policies accompanying devaluation. This statement will be developed after a detailed analysis of each simulation, focusing on the simulation properties as reflected in the specific features of the labor market. We conclude this section with some reflections on the crucial role of the formal urban wage equation in determining the simulation properties of the model.

1. Terms of trade improvement

The first simulation envisages a 20 percent increase in the international price of export crops (IPEX2), fully passed through to producers, while export taxation rates are unchanged. 28/ The dynamic effects of the shock over the four-year simulation period are reported in Table 6.

Table 6.

Terms of Trade Improvement

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Absolute changes. A minus (−) sign indicates a reduction (increase) in the migration flows from the rural (urban) sector to the urban (rural) sector. Migration flows are measured in thousands of units.

Absolute changes. The current account balance and the goverment surplus/deficit are measured in percent of GDP. A minus (−) sign indicates a deterioration of the balance.

During the first year, the producers respond to the induced change in the relative profitability of the two alternative productions by allocating more labor inputs to export crops. This stimulates export crop production by 3 percent, with a corresponding 1.6 percent drop in food crop supply, which pushes food prices up by about 12 percent. Relative price changes lead to a shift in the demand toward urban goods, which is accommodated by additional imports and import-substitutes. Migration flows to urban areas slow down by about 30,000 persons or about 1 percent of the rural active labor force. As the labor force becomes scarcer in urban areas, value added is reduced accordingly, which pushes the deflator of value added in the informal sector up by about 10 percent. In the urban formal sector, however, the deflator of value added is increased by only 3 percent. After four years, price increases in the food crop and in the urban informal sector are, respectively, in line with (21 percent) and above (23 percent) that of the export crop sector (20 percent). Urban informal producers are thus the major winners in the medium term, thereby allowing migration flows to revert to the baseline trend while remaining slightly higher in the last period. By contrast, the value-added price of manufactured goods is put back to its initial levels, as modern firms are rapidly squeezed by, on the one hand, the substantial increase in the price of other sector inputs, and, on the other hand, the price-taker position of its exporters.

Inflation as measured by the private consumption deflator is 6.7 percent higher the first year, and stays above the baseline rate during the following years, although differences are reduced to 0.8 percent the fourth year. GDP increases almost disappear after the two first years, and reach only a total of 1 percent for the four-year period, as no permanent increase in the capital accumulation of the formal sector is obtained. This modest result could, however, be improved by using the fiscal margins made available by the induced improvement in government revenue. 29/ In response to the improvement in the terms of trade, the external current account increases by 3.6 percent of GDP during the first year. This large improvement vanishes over time, though, and is reduced to 3 percent of GDP after four years. This result is attributable to the fact that, as domestic inflationary pressures bring the real exchange rate above its initial value, imports continue increasing at a sustained pace while the initial boom in agricultural exports disappears slightly over time.

2 Domestic adjustment strategy

The results of a 20 percent reduction in the nominal wages of civil servants (Wg) are presented in Table 7. The wage reduction is instantaneously and fully passed through to the wage-earners of the private formal sector (equation 13), thus inducing a 8.6 percent increase in the labor demand during the first year, owing to improving profitability and decelerating substitution of labor with capital (equation 10). The additional labor input for the formal sector is taken out of the informal sector (equation 14), leading though to a modest 1.1 percent decrease in employment, in account of the substantial difference in size between the two urban subsectors.

Table 7.

Domestic Adjustment Strategy

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Absolute changes. A minus (−) sign indicates a reduction (increase) in the migration flows from the rural (urban) sector to the urban (rural) sector. Migration flows are measured in thousands of units.

Absolute changes. The current account balance and the goverment surplus/deficit are measured in percent of GDP. A minus (−) sign indicates a deterioration of the balance.

Some indirect effects of the wage cut in the urban formal sector are perceptible in the rural sector. The food crop production suffers slightly from the decreased demand, which pushes the deflator of value added down by 1 percent during the first year. Consequently, farmers increase the time allocated to export crop production, whose prices are fixed in the world rcarket. Some of these farmers (11,000) decide to migrate to the cities because of the sharp decline in urban incomes the first year. This initial effect is however fully reversed in the following years because, as in the terms of trade shock simulation, workers in the informal sector are those who experience the largest increase in income over the medium term: while their per capita income increases by less than 3 percent the first year, it increases by about 16 percent after four years.

The GDP deflator drops during the first year by almost 5 percent, leading to an equivalent improvement in Côte d’Ivoire’s external competitiveness. Relative price developments shift demand of goods toward those produced by the formal urban sector (+4.3 percent), and away from food crops (-0.3 percent), goods produced by the informal urban sector (-0.5 percent), and imports (-0.8 percent). In contrast to the strong boost of manufactured exports, agricultural exports decline by an average annual rate of 1 percent over the four years, as an increasing share of agricultural exports is used as intermediate inputs by the manufacturing sector. GDP increases by 1.1 percent and the current account of the balance of payments improves by 0.8 percentage point of GDP. On the demand side, the contraction of aggregate private consumption is modest compared with that of household real income, as the 2.5 percent improvement in real cash balances due to the reduction in the consumption deflator lowers the savings rate (equation 24). By contrast, there is a boost of private investment, which amplifies the growth effect. Both the external current account and the fiscal balance improve progressively over the simulation period, providing after four years results similar to the terms of trade simulation (respectively, 2.5 percent and 2.4 percent of GDP), but with better growth results.

3. External adjustment strategy

The results of the third simulation are presented in Table 8. They combine some qualitative features of the two first simulations, although the quantitative results on macroeconomic variables are far less than their simple addition. As the product-wage in the formal urban sector decreases, as it did in the wage reduction simulation, output and employment in this sector rise substantially, by 2.8 percent and 5.6 percent, respectively, during the first year. The consequent reduction of the labor supply in the informal urban sector drives up the average income of informal workers as the less productive jobs are eliminated (-0.8 percent). In the agricultural sector, the producer price for export crops increases, as it did in the terms of trade simulation, which induces a shift of rural labor away from the food crop (-2.6 percent the first year) toward the export crop sector (+1.5 percent). Rural-urban migration flows strongly decelerate during the first year (-36,000 active persons) in response to the substantial increase in the relative income of rural households vis-à-vis urban households. Migration flows reverse in the following years, however, with the protracted improvement of labor demand in the formal sector, associated with improved earnings in the urban informal sector, bringing together a steady increase in the per capita urban income. First-year price impacts are about 10 percent for both GDP and private consumption deflators, thereby allowing a 10 percent depreciation of the real exchange rate.

Table 8.

External Adjustment Strategy

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Absolute changes. A minus (−) sign indicates a reduction (increase) in the migration flows from the rural (urban) sector to the urban (rural) sector. Migration flows are measured in thousands of units.

Absolute changes. The current account balance and the goverment surplus/deficit are measured in percent of GDP. A minus (−) sign indicates a deterioration of the balance.

However, as prices and incomes in the urban informal sector keep rising, this initial depreciation almost vanishes after four years.

Regarding demand effects, private consumption is more reduced than in the wage simulation, owing to negative real cash balance effects. The real impact on private investment is positive (5.6 percent in the first year), although less than in the wage simulation, thereby contributing to the protracted improvement of GDP which stabilizes at 2 percent after four years. No J-curve profile is observed for the external current account, as the competitive impacts on import and export volumes are already important during the first year. In the short run, the improvement of the current account amounts to about 1.7 percent of GDP, increasing to 2.2 percent of GDP after four years. The medium-term impact on the external current account is thus smaller than in the domestic adjustment simulation, owing in part to slightly less favorable results for the volume of manufactured exports. As far as the fiscal balance is concerned, medium-term impacts are very similar to those noted in the domestic adjustment strategy.

4. The crucial role of the formal urban wage equation

The dynamic response of the economy to each of these shocks is highly sensitive to several important features of the model employed. In particular, alternative wage setting mechanisms in the formal urban sector will affect considerably the dynamic time paths of employment, migrations, production, wages and prices. The present version of the model assumed that wages in the urban formal private sector are fully indexed to government wages, which is not contradicted by the relative stability of both wages in the 1980s in Côte d’Ivoire. There is a risk, however, that in a hypothetical real situation some downward rigidity of nominal wages would be observed in the private sector if the government cuts public wages. In that case, the results of a domestic adjustment strategy would be less favorable than those produced above. With less reduction in the product-wage, the private sector supply response would be weaker, allowing for a more modest price decrease in manufactured goods. The private sector would absorb fewer workers of the informal urban sector, whose prices would not be stimulated in similar proportions. As a result, a smaller real exchange rate depreciation would be observed.

By contrast, the results of the external strategy would not be affected by a modification of the parameter in the private wage equation, as both will remain fixed. Alternatively, if we introduced indexation of public and private wages to domestic inflation, the results of the external adjustment strategy would likely be less favorable in terms of real exchange rate depreciation.

VI. Conclusions

Our primary purpose in this paper has been to describe how a quantitative macroeconomic model featuring some key features of the labor market, in developing countries can work. While standard approaches consider a single labor market, the alternative approach developed here divided the labor market into three segments: the urban formal labor market, the urban informal labor market, and the rural labor market. This alternative approach enabled us to account for sectoral differences in wage setting mechanisms. It also enabled us to integrate migration flows between rural and urban areas and investigate how migrations affect economic activity in general, and the expansion of the informal urban sector in particular.

Although our attention has been devoted to the model itself, rather than to using it to address substantive policy problems, at least two interesting results can be derived from these simulation exercises. The first underscores how determining the degree of wage flexibility in the urban formal sector is central to the debate on the pros and cons of domestic and external adjustment strategies. The second addresses the need for policies oriented toward the informal urban sector, in particular to limit the inflationary pressures arising in the case of a currency devaluation.

The simulations presented above suggest that purely domestic adjustment strategies have comparable properties to external ones, inasmuch as they produce similar real exchange rate depreciations. However, these elements rely heavily on assumptions regarding wage formation in the urban formal sector, which are roughly adapted to the Ivoirien case in the late 1980s, but they should be subject to systematic empirical research, with a broader crosscountry base, if any generalization of these results is to be made regarding the relative advantages of each strategy. 30/

Each simulation has clearly shown how the informal urban sector plays a crucial role in the dynamic adjustment of the economy. In particular, we have seen that, by fulfilling every labor demand increase in the other sectors, this sector experiences sizable increases in nominal “wages,” which in turn feed domestic inflation. 31/ This result points out the need to have specific accompanying policies aimed at improving the performance of this sector in terms of productivity gains that are able, at least partially, to offset these inflationary pressures. Given that the model specifications do not integrate an endogenous capital accumulation in this sector, any exogenous increase in the capital at the disposal of producers in the informal urban sector will increase the output supply and reduce prices. Policies directed toward the increase of capital in this sector, through public investment or improved access to financing, are thus relevant. They will allow substantial productivity gains, as the use of capital goods is very low and substantial catch-up effects in terms of technical progress can be obtained by new equipment.

Undoubtedly, the approach developed in the present paper can be extended in different ways. First, some empirical work could be achieved to assess the relevance of the specifications used in the model, notably concerning the labor market. Second, alternative specifications could be investigated; in particular, it would be interesting to enlarge the rural-urban dichotomy to include private savings behavior. Third, econometric analysis of some basic relationships would make it possible to assess more accurately the magnitude in the adjustment of key macroeconomic variables to different types of domestic and external shocks. Fourth, the properties of the model could be examined over a larger number of simulations, in particular tax measures.