Successful Adjustment in a Multi-Sectoral Economy

This study analyzes the adjustment to a fiscal reform in a dependent economy. It evaluates the economic factors that are relevant for making the choice between a cut in employment versus a cut in wages as a means of reducing the fiscal wage bill. We demonstrate that in the presence of costly short-run mobility of labor there is a natural advantage to a wage policy over employment policy. Fiscal deficits can be dealt with successfully by a wage policy and with the corresponding adjustment in government demand. These policies may have only marginal consequences on production of traded gds in the short run in the presence of costs of adjustment. Over time the gain in the production of traded goods is determined by the credibility of the fiscal reform. It is shown that the absence of credibility may have major consequences on the adjustment, because it will depress the magnitude of the private investment associated with the fiscal reform.