Labor Market Adjustment in Chile

As a result of the Asian crisis, Chile experienced a substantial economic slowdown in 1998. Growth of the gross domestic product (GDP) among Chile's trading partners in 1998 was a full 2 percent below the previous five-year average, while terms of trade fell by over 5 percent.¹ In addition, the Central Bank of Chile applied a contractionary monetary policy aimed at minimizing the nominal devaluation and reining in the current account deficit. Interest rates on loans rose substantially in 1998—from preshock levels of 8 percent to above 18 percent in September 1998. Annual output growth fell to 3.2 percent in 1998 and then to -1.0 percent in 1999, a full 8.0 percent below the average growth rate of the previous ten years.

This collapse in output growth had an immediate effect on unemployment, which rose to an average of 8.3 percent in 1999, up from an average of 6.1 percent in the previous year and an average of 6.9 percent over the previous five years. More surprising than then initial upward jump in unemployment, however, was the slow recovery. The Chilean economy grew at an average rate of 2.9 percent between the first quarter of 2001 and the last quarter of 2002. Over this period unemployment remained relatively high, falling only 0.3 percent and averaging 9.2 percent.

The sluggish response of unemployment to improved economic conditions after 2000 led to a prolonged policy debate in Chile. One of the main concerns was that Chile experienced a labor-saving structural change in the late 1990s that aggravated the consequences of the aggregate demand shock mentioned above.² Explanations for this change included the increasing use of labor-saving technologies, the additional nonwage costs of realized (and expected) labor reforms, and the differential impact of the external demand shock and subsequent monetary policy contraction on the relatively labor-intensive small and medium-sized enterprises (SMEs).³

The distinction between a temporal (cyclical) demand shock brought about by deteriorating economic conditions and a permanent technological shock to demand has important policy implications. The former is temporary, and both employment and real wages should return to precrisis levels once external demand recovers. The latter shock is permanent (or at least strongly persistent in the case of the SME hypothesis), so employment and real wages will remain low even after external demand returns to precrisis levels.

These competing hypotheses, however, have nothing to say directly about the level and persistence of unemployment rates. Indeed, falling labor demand will only translate into higher unemployment rates if real wages are rigid. In the standard classical model, wages do all the adjusting to changes in labor demand, keeping employment stable at full employment levels.

If the quantity of labor supplied is procyclical, then changes in unemployment will mask much larger changes in labor demand. This is the case in the Chilean labor market, where labor participation has moved in step with employment over the last decade and a half. Over the period 1988-2003, changes in unemployment were generally much smaller than changes in employment growth, and the rise in unemployment following the Asian crisis was no exception.⁴ Because of this procyclical labor supply, the drastic fall in employment following the Asian crisis did not translate into even higher unemployment rates. Without this extra margin, the aggregate unemployment rate would have risen by 4.1 percentage points between 1997 and 2000 instead of the 3.3 percent actual increase.

In a related paper, we show that the response of labor supply to labor market conditions not only is procyclical, but also varies substantially across employment categories.⁵ Consequently, the rise in the unemployment rate over the period 1997-2000 was highest among highly educated young workers, but the slowdown in employment growth was largest among young workers with a low level of education. This apparent contradiction is explained by the much larger procyclical response of the labor supply among young uneducated workers.

Because of this distinction between the path of the unemployment...