Employment and Firm Heterogeneity, Capital Allocation, and Countercyclical Labor Market Policies

Many countries have large employment shares in micro and small firms that have limited access to formal financing and therefore rely on input credit. Such countries are mainly emerging and developing economies, whose business cycle dynamics are increasingly important for the global economy in light of the dramatic rise in international linkages and spillovers that have occurred over the last several decades. Emerging and developing economies implemented a host of countercyclical labor market policies amid the global financial crisis, but data limitations on high-frequency labor and job flows prevent a detailed empirical assessment of the effectiveness of these policies. To address this problem, we develop a business cycle model with frictional labor markets that is novel in light of its consistency with the employment and firm structure of emerging and developing economies. We use the model to assess the aggregate impact of key countercyclical labor market policies. We find that hiring subsidies and job intermediation services for large firms are particularly effective in aiding recoveries. Policies targeting smaller firms yield limited aggregate benefits and may even be detrimental to the recovery process. The labor market structure shapes sectoral allocation and explains the economy's differential response to policy.