On the Short-Run Effects of Labor Market Reforms

This paper evaluates the effects of introducing labor market flexibility into a small open economy characterized by tenure-increasing separation taxes. The model, which is calibrated to Argentinean observations, is subjected to different reforms: 1) the elimination of all separation costs, 2) the introduction of temporary contracts, and 3) the elimination of the separation costs from all new hires while freezing them on the workers that were hired prior to the reform. Contrary to the introduction of temporary contracts, which generate a sharp recessionary adjustment, the last type of partial reform is found to be an excellent second best alternative to a full reform. ∗This paper is based on joint work with Fernando Alvarez. A previous version circulated under the tittle “What are the Short-Run Effects of Introducing Labor Market Flexibility?”. I am indebted to Hugo Hopenhayn for very useful conversations during the early stages of this project. I would also like to thank seminar participants at Arizona State University, the Bank of Portugal, the Federal Reserve Bank of Chicago, the NBER Summer Institute, the SED Meetings, and Penn State University for their comments. The views expressed here do not necessarily reflect the position of the Federal Reserve Bank of Chicago or the Federal Reserve System. Address: Federal Reserve Bank of Chicago, Research Department, 230 South LaSalle Street, Chicago, IL 60604. E-mail: [email protected]. Phone: (312) 322-5695.