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A Technical Appendix
Mr. Lama is an Economist in the Western Hemisphere Division of the IMF Institute. Mr. Urrutia is a professor from the Economics department at ITAM. We would like to thank Felipe Meza, Sangeeta Pratap, and Jorge Roldós for their useful comments. We also receive great feedback while presenting this paper in seminars at the IMF, ITAM, and the Banco Central de Reserva del Perú. The paper was partly written while Carlos Urrutia was visiting the IMF Institute. The support of CONACYT through research grant No. 81825 is thankfully acknowledged. All errors are our own.
The Heckman and Pages indicator (H&P) measures the costs of advance notice and compulsory severance payments expressed in present value, assuming up to 20 years of tenure. Also, the World Bank publishes as part of the Doing Business Indicators a measure of the monetary costs in terms of weeks of severance payments due for firing a worker, averaged across workers of 1, 5, and 10 years of tenure. We report both indicators as they capture different dimensions of employment protection.
It is unclear whether the benchmark business cycles models for emerging economies are consistent with some basic facts about the labor market adjustment. As shown in Fernandez and Meza (2011), Aguiar and Gopinath’s calibration imply a countercyclical labor input in emerging economies, contrary to the data. In Neumeyer and Perri (2005), on the other hand, the excess volatility in output for emerging economies depends on the labor input being more volatile. However, relative to output, employment is less volatile in emerging economies compared to developing countries (see Table 1).
Following a similar approach, Den Haan et. al. (2000) show how the combination of endogenous job destruction and capital adjustment costs increases significantly the persistence of productivity shocks in the Mortensen and Pissarides framework.
For a discussion on the labor wedge see Shimer (2009). The empirical investigation in Lama (2011) shows that the labor wedge is a relevant factor behind episodes of output drops in Latin America, highlighting the importance of labor market frictions to account for the business cycle in emerging economies.
This utility function, also known as GHH, has been used extensively in small open economy models to mitigate the impact of wealth effects on labor supply. It can also be interpreted as a reduced form of a more general model of home production, as shown in Benhabib et al. (1991). This is particularly relevant for emerging economies in which self-employment and the informal sector are important.
The assumption of a matching function with constant returns to scale generate endogenous probabilities for the transition from employment to unemployment pt, and from unfilled vacancies to filled ones qt:
These probabilities depend on the labor market tightness coefficient
We also constructed an alternative version of the model in which hiring and separation costs are rebated to the planner as a lump sum transfer. The results were quantitatively very similar, so we omit them from the paper.
ENEU (Encuesta Nacional de Empleo Urbano) is a rotating panel of workers in urban areas. It includes both formal and informal workers. This data set has been used extensively to doument labor market facts for Mexico. See, for instance, the studies of Pratap and Quintin (2010) and Bosch and Maloney (2009). We are very grateful to Sangeeta Pratap for giving us access to a cleaned version of this dataset.
The transition rate from employment to unemployment is not a good measure of the separation rate for Mexico. It underestimates the level of turnover since it ignores transitions between jobs inside a quarter and movements out of the labor force.
There is a large literature on estimating the elasticity of labor supply. This literature distinguishes between the micro elasticity and the macro elasticity, finding larger value for the latter. For instance, using the response of aggregate labor supply to changes in taxes, Rogerson and Wallenius (2007) obtain a macro elasticity of labor supply between 2.3 and 3 for the US. We choose the midpoint of this range for our experiment and perform sensitivity analysis on this parameter at the end of Section 5.
This hiring cost is calibrated to a small open economy, and it has the same order of magnitude as in Shimer (2005). At the steady state the firing cost implies a loss of resources of less than 0.1 percent of GDP.
The unemployment rate corresponds to an average adjusted rate for Mexico. The separation rate is consistent with an annual rate of job destruction of 15 percent, as estimated for Mexico in Kaplan et al. (2005).
We first HP-filtered the time series from the data using the whole 1987:Q1 to 2010:Q2 sample. The plotted sequences for the interval 2007:Q4 to 2010:Q2 should then be interpreted as deviations from a long run trend. Notice that the calibration of the model discussed in Section 3 only used Mexican data from 1987:Q1 to 2007:Q3, making the results this experiment an out-of-sample prediction of the model.