Expenditure and Wage Policies in a Segmented Labor Market: A Theoretical Analysis

Abstract

Despite the crucial role attributed to labor markets in determining the supply response to adjustment policies, the implications of a segmented market remain largely unexplored. A common presumption is that adjustment policies would exert an unequitable effect because informal sector wages would decline proportionately more than in formal activities. In this paper, a formal model of segmented labor markets is used, where open unemployment is mostly a formal sector phenomenon derived from regulations setting a premium on wages. The Model assumes that the informal sector is completely unregulated and non-unionized. The paper shows that Expenditure-reducing policies unaccompanied by ad-hoc indexation schemes, do not necessarily lead to any unequitable effect in terms of the formal-informal wage gap. The paper also shows that increasing wage distortions are likely to cause an appreciation of the real exchange rate and higher open unemployment. Finally, the paper concludes that under a proportionately fixed wage distortion, expenditure-reducing policies may decrease rather than increase open unemployment.