Labor Market Policies and Business Cycles in Emerging Economies

We build a small open economy business cycle model with search and matching frictions to assess the impact of labor market policies on the dynamics of employment and other macroeconomic variables in emerging economies. The model features an endogenous selection mechanism by which inefficient jobs are destroyed in recessions, thus linking labor market dynamics and aggregate productivity. In a quantitative version of the model calibrated to the Mexican economy, we find that reducing labor taxes and increasing firing costs would have mitigated the fall in employment during the Great Recession of 2008–2009. However, by preventing firms from dismissing low-productive workers, higher firing costs would have impaired this selection mechanism, thus generating a larger fall in TFP and delaying the recovery. Cutting labor taxes, in contrast, have minor effects on productivity by mainly affecting hiring decisions. An extension of the model shows that lowering labor taxes provides an additional productivity boost by expanding formal hirings and reducing the informality rate.