Fiscal adjustment and labor market dynamics in an open economy

This paper studies the labor market effects of fiscal adjustment in a two-sector, three-good intertemporal framework. Key features of the model are an informal sector, minimum wages, unionized labor in the formal economy, imperfect labor mobility, and public production of intermediate inputs. “Luxury” and wait unemployment prevail in equilibrium. It is shown that if unions care sufficiently about employment, and if the degree of openness is high, an increase in the price of government services may reduce unemployment in the steady state. A similar result would hold in an efficiency-wage setting if the “disciplinary effect” of unemployment is sufficiently strong.