Draft From Economic Miracle To Sluggish Performanc

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Draft From Economic Miracle to Sluggish Performance: Employment,

Unemployment and Growth in the Chilean Economy 1
Article · January 2002
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October 31, 2002
Draft
From Economic Miracle to Sluggish
Performance: Employment, Unemployment and Growth

in the Chilean Economy 1
Andrés Solimano Guillermo Larraín

U.N.-ECLAC BBVA Banco BHIF
and
CEA – Universidad de Chile
1
We acknowledge the comments made to a previous version of this paper by Christoph Ernst. Efficient research
assistance by Claudio Aravena and Fernando Larrain is appreciated. The views expressed in this paper are of the
authors and do not necessarilly present those of the institutions they belong.
1
Table of Contents.
1. Introduction
2. Output, Employment and Unemployment in the Period 1960-2001
2.1 Medium and Long Run Trends
2.2 Economic Cycles: Big Recessions and Downturns.
2.3 The Post 1998 Cycle: Sluggish Growth and High Unemployment
3 Econometric Analysis
3.1 Theoretical framework
3.2 The Demand for labor: Estimates for 1960-2000
3.3 Empirical Unemployment Equations
4. Conclusions
2
1 Introduction
Problems of unemployment and difficulties in employment generation were largely absent in

Chile for most of the 1990s until the onset of the Asian and Russian crises. However, in 1998,
the Chilean woke-up to the realities of sluggish growth and the end of euphoria, after a stellar
economic performance between 1986 and 1997. GDP grew at an average over 7% per year for
12 consecutive years. In that period, economic growth was based on dynamic export growth and
was supported by high investment and national savings ratios. Macroeconomic policies were an
almost textbook example of sound management with declining inflation, fiscal surpluses, small
to moderate current account deficits and a sound banking system. By the mid 1990s, another
“economic miracle” was in the making and Chile was safely in the select group of high-
performance economies at world level. International recognition of the Chilean model in the
1990s was greatly helped by the fact that Chile recovered peacefully its democratic tradition and
a significant degree of internal consensus in contrast with the authoritarian period and divided
society that characterized Chile during most of the 1970s and the 1980s.
The dynamic performance of the Chilean economy was interrupted since 1998 by the effects of
the Asian crisis that hit Chile through declining commodity prices (copper and others) plus lower
capital inflows. A large deficit of the current account of the balance of payments and rapid
growth of internal demand made the Chilean economy vulnerable to a deteriorated external
situation. In turn, a sharply contractive monetary policy in 1998 along with a depressed
international economy has led to a protracted period of near half a decade of sluggish economic
growth, pessimistic expectations of the private sector and higher unemployment2 . Paradoxically,
an economy with “strong fundamentals” fell into a stagnationist trap with adverse consequences
on the labor market.
The purpose of this paper is to look at the capacity of job generation of the Chilean economy in
periods of boom and downturns as well as in a path of long run growth. The paper investigates
labor and goods market behavior during episodes of big recessions and more moderate cycles in
the Chilean economy in a 40-year period running from 1960 to 2001. In addition we want to
shed light on the effects of the post 1998 recession cum slow recovery cycle on unemployment
3
and other variables of the labor market. Several hypothesis of the causes of the sluggish recovery
of employment in the 2000-2001 period are examined. An important question is what can be
expected in terms of capacity of job creation, once the Chilean economy recovers its growth
momentum which will probably be somewhere between the high growth rates of the “golden
period” of 1986-1997 and the historical growth rates of the last half century or so. The paper
also provides new econometric estimates of real wage and output elasticities of the demand for
labor at aggregate and sectoral levels (manufacturing, agriculture and mining) using annual data
for the period 1960-2000; in addition we estimate empirical unemployment equations to look at
the importance of both persistence effects –or path-dependence—in the evolution of
unemployment and the sensitivity of unemployment to large macroeconomic shocks.
The paper is organized in 3 sections besides this introduction. Section 2 looks at medium run
trends and short-term cycles in the period 1960–2000 regarding the behavior of output,
employment and unemployment in the Chilean economy. Special attention is given to the post-
1998 cycle. Section 3 undertakes the econometric analysis. It reviews existing studies of the
demand for labor and estimates the demand for labor at aggregate and sectoral levels, for
manufacturing, agriculture and mining with annual data for a 40 years period. Then it turns to
the estimate of empirical unemployment equations. The paper concludes in Section 4.
2 Output, Employment and Unemployment in the 1960-2001 Period
2.1 Medium and Long Run Trends
The Chilean economy in the last 40 years experienced important changes in its overall economic
policy regime and in its labor markets institutions3 . The 1960s was the last decade of the “old ”
policy regime of the Chilean economy based on import substitution and a greater economic role
of the state. That was a relatively stable decade in macroeconomic terms, at least compared with
the 1970s and 1980s. Then it comes the turbulent 1970s with its sharp changes in policy regimes
that included both a short lived experiment with socialist economic policies in the early seventies
2
See Corbo and Tessada (2002) for an analysis of that period in the Chilean economy and an evaluation of the
policy response to the Asian and Russian crisis in Chile.
3
For a recent book analyzing comprenhensivety the last 50 years of the Chilean economy, see
4
an then a switch to free market policies started in the mid 1970s by the military regime that took
power in 1973. The 1970s was a decade of high inflation and subsequent gradual stabilization,
along with the launching of reforms comprising trade opening, privatization, capital market
liberalization and labor market reform. Also a sharp recession took place in 1975 with adverse
consequences on labor markets. In the 1980s Chile suffered a severe currency and banking crisis
in 1982-1983 that led to high unemployment. However, towards the second half of the decade it
started the recovery of the Chilean economy. The restoration of democracy in the 1990s came
along with the consolidation of market-based economic policies supplemented by more equity-
oriented4 social policies. A high-growth and low-unemployment period continued until 1998. In
1999 Chile experienced the first year of negative growth since the early 1980s followed by a
bumpy recovery of growth in 2000-2001 along with persistent unemployment.
Labor market legislation changed in the late 1970s to a decentralized regime, with more liberal
rules for hiring and firing along with a new modality of firm-level wage negotiation. Some
changes in the labor code were introduced in the early 1990s and others were recently passed in
2001, which makes more difficult for firms to fire workers, strengthening worker’s bargaining
power.
The period 1960-2000 can be divided in two different sub-periods5 according to the behavior of
economic growth and the labor market: (1) two decades, the 1960s and 1990s, of relative
macroeconomic stability, faster growth (particularly in the 1990s), lower unemployment and a
higher growth of real wages; (2) two decades, the 1970s and 1980s, of political turbulence, large
changes in economic policy-regimes, macroeconomic volatility, higher unemployment and lower
real wages (see table 1).
Regarding unemployment, we seem to be in presence of a significant shift in the unemployment–

output relationship (e.g. a sort of long run Okun’s coefficient) between the 1960s and the 1990s.
In fact, while the annual rate of growth of GDP was more than 2 percentage points higher in the
1990s than in the 1960s, also the rate of unemployment was about 1 percent higher in the 1990s
Ffrench-Davis (2002). See also Solimano (1993,1999), Corbo and Solimano (1991).
4
See Solimano, Aninat and Birdsall (2000).
5
Of course other periodization can be thought of e,g, coinciding with changes in the political and economic policy
regimes ; in section 3 a more detailed discussion and timing of policy regimes is provided.
5
than in the 1960s (see table 1). Therefore each percentage point of GDP was generating a lower
decline in unemployment in the last decade than in the 1960s.
TABLE 1
CHILE. GROWTH, UNEMPLOYMENT, REAL WAGES AND LABOR PRODUCTIVITY, 1960 - 2000
[1] [2] [3] [5]

GDP Unemployment Real Wages Average labor
Productivity
Rate of change % Rate Rate of change % Rate of change %
Annual average (%) Annual average Annual average
1960-70 4.26 6.50 5.46 2.37

1970-80 2.74 10.34 0.91 1.10
1980-90 3.58 12.63 1.35 0.05
1990-00 6.38 7.45 3.56 4.54
1960-00 4.22 9.29 2.48 2.00
Source: 1986-98 National Bureau of Statistic of Chile, 1974-85, Jadresic (1986) and 1960-74 Lefort, Budnevich y Riveros (1986), and Central Bank of Chile.
Decomposing the evolution of unemployment by changes in the supply and demand for labor in
the period 1960 -1990s, we find that the rate of growth of the labor force is marginally higher in
the 1990s than in the 1960s and the rate of growth of employment is slightly lower (see table 2).
On the demand for labor, we observe a significant decline in the capacity to generate
employment per point of growth of GDP in the 1990s. In fact, the gross output-elasticity of
employment falls from 0.44 in the 1960s to 0.29 in the 1990s (with an average elasticity of 0.52
in 1990-2000, see table 2).
6
TABLE 2
CHILE. LABOR FORCE, EMPLOYMENT AND GROWTH, 1960 - 2000
[1] [2] [3] [4]

Labor Force Employment GDP Gross Output Elasticity
Rate of change % Rate of change % Rate of change %

of employment
Annual average
Annual average Annual average Annual average
1960-70 1.76 1.90 4.26 0.44

1970-80 2.18 1.64 2.74 0.60
1980-90 2.84 3.53 3.58 0.99
1990-00 1.97 1.84 6.38 0.29
1960-00 2.23 2.21 4.22 0.52
Source: 1986-98 National Bureau of Statistic of Chile, 1974- 85, Jadresic 1986 and 1960 -74 Lefort, Budnevich y Riveros 1986, and Central Bank of Chile.
Why the decline in the employment–intensity of growth in Chile? Table 3 sheds some light on
this by looking at changes in the relative contributions to aggregate employment, of the tradable
and non-tradable sectors. An interesting feature is that the traded goods sector (defined here, in
line with Chilean national accounts, simply as comprising agriculture, mining and
manufacturing) has reduced its share in GDP by around 4 percentage points between the 1960s
and the 1990s. Most importantly for our purposes, the traded goods sector has reduced its share
in total employment from 47 percent in the decade of the 1960s to 33.7 percent in the 1990s; that
is a decline of 13.2 percent!! Most of this decline concentrates in the agriculture sector that
experienced a reduction in its share in total employment from 26.4 percent in the 1960s to near
16 percent in the 1990s. This explains around 10 percentage points of the decline of the traded
goods sector share in total employment between the 1960s and the 1990s. The rest of the
reduction in the share is in mining: less than 2 percentage points and in manufacturing, a bit over
1 percent.
7
TABLE 3
CHILE. SHARES OF TRADED AND NON-TRADED GOODS SECTORS
[1] [2] [3] [4] [5]
TradedGoods Non-traded Goods Agriculture Mining Manufacturing
(a) (b) (a) (b) (a) (b) (a) (b) (a) (b)
% of sector % of total % of sector % of total % of sector % of total % of sector % of total % of sector % of total
outputonGDP employment output on GDP employment outputonGDP employment output on GDP employment outputonGDP employment
1960-70 36.53 47.03 63.47 52.97 7.64 26.40 8.54 3.40 20.36 17.23
1970-80 35.10 42.17 64.90 57.83 6.99 21.58 8.37 2.93 19.74 17.66
1980-90 35.26 36.10 64.74 63.90 8.24 19.45 9.51 2.24 17.51 14.41
1990-00 32.56 33.77 67.44 66.23 8.04 15.96 8.73 1.76 15.79 16.06
1960-00 34.19 38.39 65.81 61.61 7.84 19.85 8.85 2.41 17.51 16.14
Source: 1986-98 National Bureau of Statistic of Chile, 1974-85, Jadresic 1986 and 1960-74 Lefort, Budnevich y Riveros 1986, and Central Bank of Chile.
These findings have important implications for the relationship between trade and
unemployment. On the one hand, the trade reform undertaken by the Chilean economy in the
mid 1970s led, over time, to a dramatic increase in the export and import shares in GDP, (see
table 4); in fact, the export share in GDP went up from near 12 percent in the 1960s to 37.2
percent in the 1990s. On the other hand, however, the traded goods sector, did not increase its
share in GDP; on the contrary its share actually fell in this period. However, the definition of
traded goods in the national account exclude activities such as tourism, commerce and banking as
trade activities that are also in a way, related to international trade and finance. Moreover, with
the traditional definition of traded activities the share of employment of the traded goods in total
employment declined consistently after the process of trade opening. It is apparent, that the
comparative advantages of the Chilean economy lie more in natural-resource intensive goods
than in labor–intensive products. This is in contrast, for example, with several low-wage Asian
economies that are notoriously competitive in labor-intensive manufacturing in world markets
(e.g. China, Malaysia, Indonesia and other; see Adrian Wood (1997)’s study). The low intensity
of employment of tradables in Chile is at odds with a simple version of the Heckscher-Ohlin
theory without natural resources and in a two-country setting – which would predict that Chile
has comparative advantages in labor intensive activities.
8
TABLE 4
CHILE. Exports and imports over GDP
[1] [2]
Exports over GDP Imports over GDP
1960-70 11.9 25.7

1970-80 16.8 30.1
1980-90 27.8 32.0
1990-00 37.2 44.1
1960-00 23.4 32.8

Source: Author's ellabor.
In addition, Table 5 shows that the output elasticity of employment in the non-traded goods
sector is significantly higher than as the output elasticity of the traded goods sector (0.71 (non-
tradable) versus 0.23 (tradables) with an average elasticity for the aggregate of 0.52).
Another factor that may account for a decline in the output elasticity of employment in Chile is
the existence of labor–saving technical change (e.g. associated with the high tech and informatics
revolution of the 1990s) that has reduced labor-output ratios and explain a decline in the labor
intensity of employment.
TABLE 5
CHILE. OUTPUT ELASTICITY OF EMPLOYMENT
Aggregate, Traded goods and Non-traded goods Sectors.
[1] [2] [3]
Aggregate Traded Goods Non-traded Goods
Sector Sector
1960-70 0.44 0.11 0.72
1970-80 0.60 0.03 0.90
1980-90 0.99 0.85 1.09
1990-00 0.29 -0.09 0.44
1960-00 0.52 0.23 0.71

9
TABLE 6
CHILE. GROSS OUTPUT ELASTICITY OF EMPLOYMENT
Agriculture, Mining and Manufacturing
[1] [2] [3]
Agriculture Mining Manufacturing
1960-70 - - 0.5
1970-80 0.0 - 0.1
1980-90 0.4 0.6 1.2
1990-00 - - 0.1
0.22 0.33 2
1960-00 0.0 - 0.5
Turning to supply side of the labor market, we find that the rate of growth of the labor force
accelerated in the 1970s and 1980s and declined again in the 1990s (table 2). This reflects a
complex interaction among demographic factors, increasing female participation in the labor
force, and business cycle considerations. In any case, this evidence seems to suggest a tendency
for the labor force to rise in “bad” times (e.g. more members of a household are looking for jobs
when overall household incomes tend to fall). In turn, there was a slow-down in labor force
growth in better times (e.g. the 1990s). As shown in figure 1 since the mid 1970s it is noted an
upward trend in female participation rates.
10
Figure 1.
CHILE. Female Participation in the Labor Force
40
35
30
25
20
15
10
Years
Source: National Bureau of Statistic of Chile
Female Participation in the Labor Force
To conclude this section we can pose the question: Is there a trend towards a higher long run
(structural) rate of unemployment in Chile? Has the “natural” rate of unemployment increased?
The answer to these complex questions depends on a host of factors: structural mismatch
between vacancies and unemployment (shape and shifts in the Beveridge curve), the costs of job-
search for the unemployed, the possibility of capital (physical and human) constraint that
generates a labor-surplus at full capacity, size of hysteresis effects, and the degree of flexibility in
labor markets. We will return to this later in the paper in the estimates of empirical
unemployment equation. However, the analysis here suggests that given the relatively low (and
apparently declining) output elasticity of employment, for a given rate of growth of the labor
force a higher rate of growth of GDP is needed to prevent a higher rate of unemployment. Then
without a rapid and steady acceleration in the growth rate of the Chilean economy well above its
current levels of 3% per year, it is unlikely to observe any significant decline in unemployment.
11
2.2 Economic Cycles: Big Recessions and Downturns
In this section we look at the economic cycles of the last 40 years in Chile. In this period we can
identify two big recessions in 1975 and 1982-83, several downturns (mild-intensity cycles) in
1965, 1970, 1990 and a moderate-size recession in 1999 followed by a sluggish growth cycle that
still continues in early 2002 when this paper is being written. An understanding of these
previous cycles (their intensity, speed of recovery, etc.) can help to grasp better the nature of the
current cycle initiated with the the recession of 1999 and associated with the both the Asian and
Russian crisis and the internal policy response to those external events.
In the recession of 1975, GDP declined by 13.3 %, unemployment rose sharply and remained
high for several years. In the recession of 1982-83 there was a cumulative GDP decline of 16.9
% (see table 7) and a sharp rise in unemployment. Regarding the speed of recovery of output and
(un)employment after the initial decline in output (see table 7) in both cycles it took about 3 to 4
years for GDP to recover their pre-recession (3 year-average) levels. However, after the
recession of 1975, unemployment never recovered its level of the 1960s. In the aftermath of the
1982-83 recession, it took about 4-5 years for the unemployment rate to return to their pre-
recession levels (late 1970s and early 1980s). Nevertheless, those unemployment levels were
higher than the historical levels of say the 1960s. The recession of 1999 is of a lower severity
than these two previous recessions although the increase in unemployment and its persistence are
still serious.
12
TABLE 7
CHILE. Three Economic cycles
Cycle [1] [2] [3]

GDP Unemployment Real Wages
Rate of change % Rate (1970=100)

Annual average (%)
Before and after
recession 1975
1960-73 3.5 5.8 79.6
1974 1 9.1 64.8
1975 -13.3 15.7 62
1976 3.2 16.6 65
1977 8.3 13.3 71
1978 7.8 13.8 75
1979 7.1 13.5 81.8
Before and after

recession 1982-83
1980 7.7 11.7 88.9
1981 6.7 10.4 96.8
1982 -13.4 19.6 97.1
1983 -3.5 18.7 86.5
1984 6.1 16.3 86.7
1985 3.5 13.8 83.2
1986 5.6 12.1 84.6
1987 6.6 10.9 84.3
Before and after

recession 1999
1997 7.4 6.1 126.1
1998 3.9 6.2 129.5
1999 -1.1 9.7 132.6
2000 5.4 9.2 134.4
2001 2.9 9.3
Source: 1986-98 National Bureau of Statistic of Chile, 1974-85, Jadresic 1986 and 1960-74 Lefort, Budnevich y Riveros 1986, and Central Bank of Chile.
One hypothesis for the more rapid recovery of employment and a faster decline in unemployment
in the aftermath of the 1982-83 than in post-1975 recession, for relatively similar recoveries of
output growth, is that the labor legislation code prevailing at that time, say in the early 1980s,
was more flexible thereby reducing the costs of hiring and firing and relaxed other labor market
“rigidities”. In section 2.C of this paper we discuss further the effects of changes in labor market
legislation and in section 3A we investigate the impact of the degree of labor market flexibility
on the demand for labor. In any case, it is hard to argue that the labor market was “very rigid” in
the mid-to-late 1970s in Chile: on the one hand, there were severe restrictions on labor union
activity imposed by the military regime that weakened the negotiating power of workers, also
13
partial indexation helped to compress of real wages and general slack prevailed in the labor
market. In any case, the legal restrictions for firing labor were objectively higher in the
aftermath of the 1975 recession than in the wake of the 1982-83 recession. Finally, we should
mention other factors that impinge in the speed at which firms increase their demand for labor
after a recessionary period such as the expectations of firms of higher demand in the future, the
existence of idle physical capital, the availability of labor of the required skills, the availability of
credits to firms to finance working capital and/or project financing.
TABLE 8
CHILE. Speed of adjustment of output, unemployment and real wages during cycles.
(Number of years to recover to pre-recession, 3 years average)
[1] [2] [3]

GDP National Real Wages
Unemployment Rate
Recession of 1975 3 years - 4 years
Recession of 1982-83 4 years 4 years 5 years
14
TABLE 9
CHILE. National Unemployment Elasticity to GDP
[1] [2] [3]

GDP Change in Output Elasticity
Rate of Unemployment of Unemployment
change %
Recession years
1975 -12.9 9.7 -0.8
1982-83 -8.2 7.2 -0.9
1999 -1.1 3.4 -3.0
Recovery years
1976-79 7.5 -1.3 -0.2
1984-87 5.0 -5.9 -1.2
2000-01 4.1 -0.5 -0.1
[1] GDP growth rate.

[2] Change with respect to 3-year average for the recessions years and change with respect to the
average unemployment level of the recession for the recovery years
[3] = Change in unemployment/ GDP growth rate
15
Figure 2.
CHILE.Open Unemployment Rate
25.0
20.0
15.0
10.0
5.0
0.0
Years
Open Unemployment Rate
2.3 The Post-1998 Period: Sluggish Growth and Higher Unemployment
2.3.1 Macroeconomic background
Since the thai devaluation of June 1997 that marks the start of the Asian crisis, the international
economy has witnessed years of high instability. Thailand was followed by Malaysia, Korea and
Indonesia and the outcome was the most dramatic recession that any of the Asian tigers had
suffered up to that moment. One year later came the Russian devaluation and default that
became a real systemic shock to world financial markets. Six months later Brazil devalued it
currency and, contrary to all expectations, this was the least dangerous and the most successful
experience of all. Finally in 2001 the three major economies, US, Japan and Germany, all
suffered a recession. More recently, the collapse of the exchange rate regime in Argentina in late
2001 and early 2002 along with a severe balance of payments and banking crisis and sharp
contraction in economic activity adds a new crisis this time in a country very close,
geographically, to Chile.
When the waves of the Asian crisis reached Chile, the economy was growing rapidly at 7,4% in
1997 and there was evidence that the economy suffered from excess expenditure relative to
16
output. In fact, the current account deficit was 5,0% of GDP in 1997. Indeed, only in 1997 Chile
received 22,4% of GDP in gross capital inflows, absorption ended the year growing at 13,1% and
the real exchange rate appreciated 8,4% in 12 months. All of these imbalances needed to be
corrected. The problem relied on the instruments used for that purpose.
On the fiscal front, there were two readings of the fiscal stance. One was that public outlays
were increasing faster that GDP, hence inducing some agents to talk about an expansionary fiscal
policy. Another reading is that tax revenues were increasing faster than public spending resulting
in an increase of the fiscal surplus leading to a negative fiscal impulse. Even though the
government thought the second argument was correct, during 1998 it cut public expenditures on
three occasions by a total of 1% of GDP 6 .
At that time, Chile had an exchange rate policy consisting in a band or target zone; the exchange
rate, due to the large capital inflows, was in the lower (appreciated) extreme of the band. In
principle, the peso had room to depreciate up to a 25% in nominal terms so as to accommodate
the external shock. However, the Central Bank was concerned with the potential effect on
inflation of such a depreciation7 . Indeed, at the time the Central Bank of Chile was following a
strict and very rigid inflation-targeting scheme. This rigidity in the inflation target induced
monetary authorities to react to the external shock with a policy mix biased towards monetary
restraint to curb possible inflationary pressures instead of using exchange rate policy to enable a
real depreciation of the exchange rate in face of the adverse terms of trade shocks, decline in
export demand and cut-off of capital inflows, all taking place at that time8 .
This policy mix of a very contractionary monetary policy, a mildly restrictive fiscal policy9 and
no exchange rate adjustment until 1999, was in place one year after the initial shock. As a result
of these policies in the short run only the demand reducing effects of an adjustment package were
in place as the possibility of a real depreciation of the exchange rate was ruled –out, apparently
6
This reflects the inability Chile, as probably any other emerging economy, has to implement a serious counter-
cyclical macroeconomic policy. See Ffrench-Davis and Larrain (2002).
7
See Morandé (2001).
8
See Corbo and Tessada (2001).
9
Fiscal policy was contractionary ex ante. Ex post it was not so because of an unexpected decrease in inflation and
the severe drop in domestic spending, beyond any reasonable forecast.
17
for a fear of an inflationary impact that an overzealous Central Bank was not willing to accept.
Lower inflation had priority over higher growth and employment.
2.3.2 Employment Adjustment between 1997 and 2001
Table 10 shows the evolution of employment, labor force and real wages in the period 1997 –
2001, using quarterly data. We can extract four conclusions from this table:
(a) labor force growth was mildly pro-cyclical. Considering that annual population
growth in Chile is close to 1,4% and the increase in female participation rates, the
deceleration in labor force growth from 1,8% in 1997-99 to 0,5% in 2000 seems to be,
basically, a cyclical correction. However, the aggregate hides very dissimilar
behavior of the primary and secondary components of the labor supply10 . While the
primary component was counter cyclical, the secondary component was procyclical;
(b) job destruction concentrated in 1999 only. Both primary and secondary employments
were destroyed, but the firms adjustment were most profound among youngsters and
the elderly. In 2000, the economy grew 4,4%, but employment recovered only 1,0%.
This mild recovery in employment was also more intense in the latter two categories
than in primary workers. Some analysts have argued that this is because the economy
has lost its capacity to generate jobs, e.g. that the output elasticity of labor demand
would have fallen11 .
10
In this paper, primary labor force and employment are defined as that of people within the 25 to 54 years old,
male and female. Secondary figures concern people in the ranges 15 to 24 and more that 55.
11
Martinez, Morales and Valdés (2001) test this hypothesis and found no evidence of that using quarterly data. In
section 4 of this paper, the same result obtains with annual data.
18
Table 10. The labour market in Chile: 1997-2001
Labour Force Growth Employment Growth
Unemployment Real Wage
Total Primary Secondary Total Primary Secondary
rate Growth
1997 Q1 0.2% 0.8% -1.2% 1.6% 1.3% 0.3% 5.6% 2.8%
Q2 1.4% 1.3% 1.5% 1.4% 1.4% 1.5% 6.3% 3.1%
Q3 3.2% 2.3% 5.5% 3.5% 2.5% 6.3% 6.7% 2.3%
Q4 2.2% 1.9% 3.2% 2.1% 1.7% 3.3% 5.9% 1.4%
1998 Q1 1.6% 1.9% 0.8% 2.0% 2.3% 1.1% 5.2% 2.1%
Q2 1.9% 2.3% 1.0% 2.6% 2.8% 2.1% 5.7% 2.7%
Q3 1.2% 2.2% -1.1% 1.3% 2.0% -0.7% 6.7% 2.7%
Q4 2.6% 3.8% -0.6% 1.3% 2.5% -2.0% 7.1% 3.1%
1999 Q1 2.3% 3.6% -1.2% -0.4% 0.9% -4.1% 7.7% 2.7%
Q2 1.8% 3.0% -1.5% -2.6% -1.2% -6.6% 9.8% 2.1%
Q3 1.5% 2.5% -1.2% -3.6% -2.0% -8.0% 11.3% 2.4%
Q4 1.5% 1.5% 1.5% -1.7% -1.1% -3.2% 10.0% 2.5%
2000 Q1 1.3% 0.7% 2.9% 0.8% 0.5% 1.7% 8.2% 1.7%
Q2 0.9% 0.2% 3.0% 1.9% 1.2% 3.9% 8.9% 1.4%
Q3 0.5% 0.4% 0.7% 1.4% 1.2% 2.1% 10.5% 1.4%
Q4 -0.7% -0.4% -1.6% 0.1% 0.3% -0.4% 9.3% 1.1%
2001 Q1 -1.1% -0.2% -3.4% -1.5% -0.8% -3.3% 8.5% 1.4%
Q2 -0.5% 0.2% -2.4% -1.1% 1.3% 0.9% 9.4% 1.7%
Q3 0.7% 0.3% 1.5% 1.4% 0.7% 3.3% 9.9% 1.6%
Q4 1.4% 0.8% 3.4% 1.9% 1.0% 5.0% 8.8% 1.4%
Averages
1997 1.8% 1.6% 2.3% 2.1% 1.7% 2.8% 6.1% 2.4%
1998 1.8% 2.5% 0.0% 1.8% 2.4% 0.1% 6.2% 2.7%
1999 1.8% 2.7% -0.6% -2.1% -0.9% -5.5% 9.7% 2.4%
2000 0.5% 0.2% 1.2% 1.0% 0.8% 1.8% 9.2% 1.4%
2001 0.1% 0.3% -0.2% 0.2% 0.5% 1.5% 9.2% 1.5%
Minimum -0.7% -0.4% -3.4% -3.6% -2.0% -8.0% 5.2% 1.1%
- Maximum 3.2% 3.8% 5.5% 3.5% 2.8% 6.3% 11.3% 3.1%
Source: National Institute of Statistics (INE)
Note: According to the INE, primary refers to people considered “head of household” understood as the
main contributor to family income. Secondary refers to the second contributor to family income.
(c) after the increase in unemployment that took place in 1999, unemployment has not
declined significantly afterwards. Some analysts have suggested this is not a cyclical
phenomena but a structural one;
(d) real wages have grown continuously during this cycle, whereas at a slightly slower
pace, especially in 2000. Some analysts have suggested that the lack of full wage
flexibility induced by a minimum wage legislation passed in 1998 have prevented a
proper adjustment in the labor market and hence created and maintained a high
unemployment rate. More recently the changes in labor legislation passed in late
1999 may contribute, according to these observers, to postpone a more rapid increase
19
in employment due to the increases in the costs of changing the labor pool at firm
level.
As a conclusion, the main characteristic of the recent developments in the labor market have
been (a) the high number of jobs destroyed during the crisis and (b) the low number of jobs
created after the crisis despite the fact the GDP in 2000 is 7% higher than that of 1998, the year
prior the recession.
2.3.3 Why so few jobs have been created in 2000-2001? Eight Hypothesis.
The Chilean economy contracted in 1999 but it managed to recover more strongly in 2000 to
decelerate in 2001 (the average growth rate was near 4% per year in 2000-2001). This represents
positive growth but it is still well below the rapid pace of growth of the golden years 1986-
199712 in which GDP grew at around 7%. However, what is worth nothing is that the recovery of
employment in 2000-2001 has been very modest with an average annual increase in 2000-2001
of just 0.6 percent. Unemployment has remained near 10 percent in these two years. This has
been a controversial issue in the discussion concerning the labor market and macroeconomic
policies. Several hypothesis, whose validity are assessed here, are put forward to explain this
slow recovery of employment:
A. Modifications to the Labor Code. Prior to the 1999 presidential elections, the government
proposed a labor code reform which received significant criticism from the entrepreneurial
community. The newly appointed government announced in early 2000 that it would send an
important modification to the Labor Code and the proposed changes were approved by
parliament and entered in force in early December of 2001. This modification was perceived
by the public as making more expensive the costs of dismissing workers and therefore
increasing the costs of hiring them in the first place. The proposed reform also gave
emphasis to the formation of unions, hence probably reduce the discretionary power of firm´s
owners and managers to dismiss workers. Mizala and Romaguera (2001) argue that the
degree of confrontation reached during the discussion of this bill is an obvious indication that
there is divergence of opinions in the new labor legislation. That tension is created by the
12
See Solimano (1999, 2001) for analysis of the Chilean economy in the period of the period 1986-1998.
20
conflicting claims; on the one hand organized workers demand the enforcement of the labor
code (between 16% and 25% of the norms are reportedly violated) and on the other hand, we
have the demand of entrepreneurs to make the market more flexible.
Explaining the lack of employment creation during 2000-2001 by the anticipation of changes
in the labor code does not seem very plausible. First, it was not a certain event that the
reform of the labor code was indeed to be approved and which changes were to be introduced
in the final project. The main argument to sustain that the eventual bill would have destroyed
jobs massively could only be justified on the grounds of a significant credibility loss
attributed to the project, something difficult to prove. Indirectly, however, one can be skeptic
about the argument given the behaviour of relevant macroeconomic prices at the time, like
country risk premia or long term interest rates. Second, the quantitative importance of the
expectation of a rise in the costs of hiring and firing labor on the demand for labor (quite
inelastic to real wages) is an open question. In a later section we provide econometric
estimates concerning this elasticiy. In a recent paper Bergoing and Morandé (2002) argue,
using a calibrated RBC model, that the evolution of employment can be reproduced imposing
a tax on wages of around 6%. The authors argue that such a small number could be conceived
as a consequence of the proposed labour reform. Their analysis has however a number of
shortcomings, the most important of which is that their model lacks a demand side. Hence, if
demand suffered an exogenous shock, like the sudden-stop of capital inflows, their model
will explain the macroeconomic impact of that shock with a supply side answer like the
eventual increase in the cost of labor. Clearly, the whole issue requires more research13 .
B. Minimum wage increases. During the nineties and before 1998, the minimum wage was
increased by 297% in nominal terms without any apparent adverse effect on job creation, at
least at aggregate level. Indeed, Bravo and Vial (1997) conclude that there was no evidence
of negative effects of minimum wages on employment in a period of rapid economic growth.
However, in 1998 in spite of growing uncertainty regarding the external environment facing
the Chilean economy, the minimum wage was increased substantially (11,9% per year on
average) on the basis of a three-year program. Recent evidence provided by Bravo and
21
Contreras (2001) conclude that the latter increase in minimum wages did, indeed, have a
negative impact on secondary employment. Hence, it may be the case that the sharp drop in
employment in that segment of the market could be explained by a too high minimum wage
for secondary employment.
However, before 1998 the secondary minimum wage was 86,1% the level of the primary
minimum wage. The measures adopted in 1998 made that proportion to fall to 82,4% in
1998, 79,2% in 1999 and 77,4% in 2000. Hence, in relative terms the secondary minimum
wage fell since 1998 and therefore, if something, this argument cannot explain much of the
overall decrease in employment.
Minimum Wages in Chile, 1990-2002
Primary Secondary
Ch$, July 2002 % Change Ch$, July 2002 % Change % Primary
1990 69,282 17.8% 59,636 17.9% 86.1%
1991 71,006 2.5% 61,108 2.5% 86.1%
1992 72,561 2.2% 62,446 2.2% 86.1%
1993 76,539 5.5% 65,868 5.5% 86.1%
1994 76,975 0.6% 66,244 0.6% 86.1%
1995 80,772 4.9% 69,512 4.9% 86.1%
1996 82,973 2.7% 71,408 2.7% 86.1%
1997 85,931 3.6% 73,950 3.6% 86.1%
1998 91,887 6.9% 75,748 2.4% 82.4%
1999 99,557 8.3% 78,842 4.1% 79.2%
2000 106,062 6.5% 82,414 4.5% 77.7%
2001 108,044 1.9% 83,630 1.5% 77.4%
2002 111,200 2.9% 83,703 0.1% 75.3%
Source: Ministry of Labour
C. Labor saving technical progress. As stated before, new innovations in the technologically
advanced economies (e.g. the information and high-tech revolution of the 1990s) have been
labor-saving. Chile is an importer of new technologies. As seen in the previous section,
labor-savings technical progress lowers the labor intensity per unit of output. Moreover, it is
still an open question the quantitative importance of technical change during a recession.
13
In the context of European unemployment see role of labor market institution and their interplay with
macroeconomic shocks in Blanchard, 1999
22
The real problem is not that (labor–saving) technical progress frees some labor, but that the
workers released in contracting activities do not get absorbed in expanding activities. This
may reflect several problems in the way the labor market operates such as lack of information
on job openings, transaction costs, workers without the required skill composition in
expanding activities and lack of retraining facilities. In the empirical part of the paper, we
explicitly estimate the effect of technical progress on employment. Whether or not it can be
labelled “labor-saving” shall depend upon the sign of the parameter in the equation.
D. Real exchange rate and depreciation and weak external demand. The significant depreciation
of the real exchange rate that took place since 1999 onwards should lead to a reallocation of
resources toward the tradable sector. However, the expansion in tradables have been
hampered because of the slow-down in global growth and especially the decline in export
prices of Chilean goods. Moreover, from the viewpoint of job creation, we should remind
that the labor-absorption capacity of the tradable sector is smaller than that of the non-
tradable sector.
E. Accumulated Inefficiencies. During the long expansionary cycle that preceded the 1999
recession, firms in Chile -- like in most countries enjoying a long period of prosperity—
apparently accumulated inefficiencies that were not initially binding because the economy
was growing fast. However, during a recession existing inefficiencies emerge more clearly.
In addition, recessions change the focus of management, from profit maximization to the dual
problem of cost minimization under a demand constraint.
An interesting literature dealing with the correction of inefficiencies during recession belongs
to the pre-Keynesian, “liquidationist”, school associated with economists such as Hayek,
Pigou, Robbins and Schumpeter. In that tradition, recessions should not necessarily to be
considered as “an evil” (in Schumpeter (1934) words) but as an opportunity to correct
inefficiencies, restructure organizations and cut-off low-productivity jobs14 . This approach
takes a somewhat optimistic view of unemployment in the sense that it would be the outcome
14
Creative destruction may be a source of endogenous growth, see Aghion and Howitt (1994)
23
of firms engaging in efficiency gains which later will leave them better prepared to grow
more efficiently.
Caballero and Hammour (1999 and 2000) have investigated the plausibility of what they call
the “cleansing effect of recessions”. Using micro-data for the U.S manufacturing, the authors
test the relative importance of reorganizations during recessions following the claims of the
pre-Keynesian, “ liquidationist ” school. These authors study the cumulative impact of
recessionary shocks on creation and destruction of jobs and productive capacities.
Surprisingly, recessions seem to reduce the amount of restructuring in the economy
(Caballero and Hammour, 2000, pp. 24). However, the authors caution that given the
limitations of the data their conclusions should be considered only as tentative.
For Chile the evidence of the effects of recessions on restructuring seems to be scant at best
and it is another obvious area for further research. However, casual evidence of consulting
firms recognize that there seem to have been a significant effort on restructuring at the firm
level but hard data on this is not much available.
F. Lack of aggregate demand and restrictive monetary and fiscal policies. This explanation
focuses in the large drop in private consumption and gross capital formation observed in
1999. As shown in the following table, in a relatively mild recession in which GDP fell only
1.1% in 1999, absorption fell by an astounding 10% decomposed in 3.1% drop in private
consumption and a 17.4% decline in gross fixed capital formation.
24
Table 11. Macroeconomic indicators of Chile, 1995-2001
Gross Fixed Capital

Formation
Inflation Gross
GDP Absorption (end of National Public External Private Government
growth growth period) Saving RateSavings Savings % real GDP Growth ConsumptionConsumption
1995 10.6 16.2 8.2 23.8 5.4 2.1 30.6 23.5 9.8 4.2
1996 7.4 7.9 6.6 21.4 5.8 5.1 31.0 8.9 9.4 4.0
1997 7.4 9.1 6.0 21.6 5.6 5.0 32.2 11.5 8.2 5.1
1998 3.9 3.9 4.7 21.8 4.1 5.7 32.2 4.1 4.3 3.8
1999 -1.1 -10.0 2.3 22.0 2.4 0.1 26.9 -17.4 -3.1 2.5
2000 5.4 7.2 4.5 20.4 3.5 1.3 26.3 2.8 2.5 5.0
2001p 2.9 -0.5 2.6 20.0 3.3 1.7 26.5 2.6 3.2 5.3
Source: Central Bank of Chile
Were fiscal and/or monetary policies more contractionary than needed? Did demand
contraction impair future recovery? In the case of fiscal policy, the immediate reaction to the
recession in 1999 was to pass from a decade-long fiscal surplus to a fiscal deficit. This fiscal
deficit reached 1.4% of GDP and public savings fell from 4.1% of GDP in 1998 to 2.4% in
1999. The incoming government in 2000, adopted a new fiscal policy labeled “1% (of GDP)
structural surplus15 ”. Under that policy the actual fiscal deficit fell to a transitory surplus of
0.1% in 2000 and again a deficit in 0.3% in 2001. The main question here is to what extent
such a policy was too stringent in the short run for an economy timidly recovering from the
recession of 1999. Nevertheless, the room for expansive fiscal policy may have been limited
too. On the one hand, given the size of the drop in domestic demand (10% of GDP)
compared to the size of government (21% of GDP), a strong counter-cyclical fiscal policy
would have implied a not manageable increase in the size of government. On the other side,
for signaling reasons, it is not clear that a more expansionary fiscal policy could give adverse
signals to the private sector that, in its turn, could partially offset the effect of a more
expansionary fiscal policy.
As far as monetary policy is concerned, was the monetary crunch of 1998 too large? to what
extent the monetary relaxation that took place thereafter came too late? was it too timid?
Moreover during the first half of 2000 the Central Bank revised upwards it target interest rate
15
See Marcel, Tokman,Valdés and Benavides (2001).
25
and rates were rised again when there were no signs of recovery in private consumption and
investment. Afterwards, the Central Bank has more or less followed the U.S Federal Reserve
and in early 2002 cut interest rates to historical lows only in the second quarter of 2001.
Hence, it may be that the Central Bank for a while did not contribute much to the recovery of
consumption and investment perhaps validating pessimistic sentiment towards the future of
consumers and investors. In addition, the very high interest rate of 1998 led to a sharp cut in
capital formation that has not been yet fully recovered and that impairs future potential
growth. In addition, the two sectors that destroyed most of employment, manufacturing and
construction, are the two most sensible to monetary shocks (see Larrain and Larrain, 2002).
G. Slowdown in potential GDP growth. Another hypothesis often mentioned to explain the
sluggish performance of the Chilean economy in the last four years is that, since 1998 Chile
has lost its reform momentum which, along with a cut in capital formation, is leading to a
slowdown in potential GDP growth. This hypothesis is supported by a recent paper by
Fernandez-Arias and Montiel (2002). They decompose the Latin American per capita growth
record by several contributing factors, including structural reforms. In their calculations,
Chile suffers an annual potential growth shortfall of 0,04% in the nineties compared to the
seventies16 . This result up to 1998 is counter-intuitive. Although, one could expect some
sort of diminishing returns to first generation reforms, up to 1998 investment rates were still
high, which contributes to more, and no less, potential GDP growth. Moreover, the upgrade
in infrastructure in the 1990s must also have contributed to improve potential GDP.
The slowdown in the rate of investment since 1998 is worrisome. As we saw in section 2 the
rate of unemployment, even in the presence of high levels of growth, was higher than in the
1960s suggesting the possibility of insufficient capital stock to generate full employment.
The decline in investment rates is definitely not good news for long-run unemployment.17
16
The typical Latin American country improved its situation. Chile, Argentina, Bolivia, El Salvador, Jamaica, Peru
and Venezuela all reduced their potential growth. Chile is the country less afected by this fact according to
Fernandez-Arias and Montiel (2002).
17
In the literature on unemployment in Europe in the 1980s, this phenomena was investigated in terms of a “capital
constraint”(see Modigliani et.al. 1987).
26
Using growth accounting models and plausible determinants for TFP growth, Coeymans
(1999) and Gallego and Loayza (2002) also recognize some deceleration of potential growth
in recent years. Coeymans emphasize that openness to trade is one of the main explanations
for the rapid growth Chile has experienced since the mid eighties. But he asserts that
openness to trade affects the level of productivity, implying that there are decreasing returns
to that specific reform. In its turn, Gallego an Loayza suggests that 45% of Chilean growth
since 1985 can be explained with the traditional variables that appear in the litterature. They
also suggests that almost 30% of that growth can be explained by variables such as the
quality of the political system and governance and the comprehensivemess and
complementarity of policy reforms. The relevance of this institutional variables was first
stressed by Jadresic and Zahler (2000).
H. The role played by small and medium size enterprises (SMEs). Data from the International
Labor Organization shows that approximately 33% of total private, non-agricultural
employment is generated by firms hiring less than 50 workers each the sop called SME
sector. If we add all the agricultural sector to this figure, then we have that almost half of
private employment is generated by less than 50 workers firms. The following graph shows
that SME´s employment destruction has been a key feature both in explaining overall job
destruction and sluggish job creation in the post recession period.
27
Figure 3.
Chile: Annual rate of employment growth in private firms by size
1999-2001
8.0
6.0
Up to 49 workers
4.0 More than 50 workers
2.0
0.0
-2.0
-4.0
-6.0
-8.0
-10.0
III-99 IV I-00 II III IV I-01 II III
Source: own elaboration based on ILO data.
Why this trend? Balance sheets of large registered firms show a reduction in unit mark-
ups. Despite this, overall return on equity remains grossly constant after a correction by
the business cycle. This means that large firms have been able to improve productivity,
earning less by unit of production and selling more goods.
The SME sector have also suffered increased competitition in good markets, and probably
also reduced their unit mark ups. However, their ability to compensate that with
significant productivity improvement is limited. Small and medium scale enterprises
face, often, a higher cost of capital and/or lower availability of credit than large firms.
All this prevents this segment to recover more strongly and contribute, given their often
high labor intensity than large firms to a recover of employment.
28
Evaluation
Some hypothesis discussed to explain the slow pace of job creation in 2000-2001 are better to
explain employment difficulties in the short run. Other hypothesis reviewed, however, focuses
more in the medium run capacity to generate employment. In the short run, it seems clear that
slow and volatile GDP growth in the last four years has hampered a stronger recovery of
employment in the Chilean economy. In addition given the apparent tendency for the output
elasticity of employment to decline we face the unfavourable mix of slow growth and reduced
job creation per unit of output. The modest recovery in output, in turn, has been associated with
pessimistic expectations and not very supportive demand management policies. Also, the switch
of employment to the traded goods sector than can be expected following the real depreciation of
the peso probably had modest effects on job creation on account of depressed external prices of
traded goods and a low labor intensity of the traded goods sector.
Looking at the medium run, structural unemployment may develop if capital formation does not
accelerate and the labor market does not correct inefficiencies regarding mismatch between
vacancies and openings, skills mismatch and low efficiency of search. The effects of the change
in labor legislation are bound to affect employment more in the medium run. The possible
unemployment effects of the new labor code approved in late 2001 are still hard to determine. In
addition, firm level restructuring, liquidations and labor saving technical change are bound to
affect job destruction and creation with, a still unclear possible impact on structural
unemployment.
3 The demand for labour in Chile: Econometric Estimates for 1960-2000
This section provides econometric estimates of the elasticities of the demand for labor with
respect to output and real wages. The increase in unemployment after the crisis of 1975 and
1982-1983 and the subsequent persistence of high unemployment gave rise to several empirical
studies of labor demand in that period.18. The recession of 1999 has brought renewed interest on
18
See for instance Solimano(1983), Jadresic (1986), Riveros and Arrau (1984), Rojas (1987), Meller and Labán
(1987) and Marcel (1987). In the nineties we can remark the works by Paredes and Riveros (1993) and García
(1995).
29
labor demand issues. Existing empirical studies tend to detect low-to moderate-size output-
employment elasticities. In addition, this research detected often low real wage elasticities.
Solimano (1983) estimated demand for labor equations with costs of adjustment for the
manufacturing sector at two-digits level and distinguished between short run and long run real
wage and output–employment elasticites. For the manufacturing sector as a whole the long –run
output-employment elasticity is 0.458 although the values of that elasticities vary across two-
digits industrial branches. The real wage elasticity in that study is very low in the short run –0.08
but higher, –0.394 in the long run. The real wages-employment elasticities obtained from partial
equilibrium studies of labor demand must be compared with elasticities obtained from a
macroeconomic approach. Solimano (1986) sets up a macro model that distinguishes among
three different macroeconomic regimes (classic, keynesian and externally-constrained economy)
and obtains a real wage elasticity of -0.14 (external constraint, short run) and -0.39 (classic
regime). These macro-based elasticities do not differ much from partial equilibrium demand
estimates.
Rojas (1987) estimates an aggregate demand for labour with partial adjustment that depends on
expected real wages. The Rojas (1987) study shows an output elasticity of employment of 0.45 in
the short-run and 0.69 in the long run. These results lie in the same range of Marcel (1987).
The real wage elasticities of Marcel (19870 where –0.29 and –0.46 in the short-run and long-run
respectively. Meller and Labán (1987), using a Kalman filter technique that yields variable
coefficients over time, obtained different elasticities depending on the period of analysis. They
found that in the period 1974-1981, at the aggregate level, the output elasticity was stable at
around 0.56, while for the rest of the period, 1982-1985 the income elasticity varied within the
range 0.56-0.82. They also estimated the real wage elasticity by period; for 1975-1977 the value
was near to 0, in 1977-1981 is -0.02 and in 1982-1985 is near –0.09. Paredes and Riveros (1993)
estimate an aggregate demand for labour and also for the industrial sector. Their findings are that
the output elasticity before and after the labor reforms in 1979 where 0.25 and 0.75 for the
aggregate respectively, 0.84 and 1.24, for the industrial sector. Finally García (1995), found that
the output elasticity varies between 0.3 and 1.3 for the short-run and long run. In the case for
real wage elasticity his range is between –0.03 and –0.1.
30
Table 12
Previous estimates in the literature of elasticities for labor demand

[output] elasticity [real wage] elasticity
Solimano (1983) 0.093 short term -0.08 short run
0.458 long run -0.394 long run
Rojas (1987) 0.45 short run
0.69 long run
Meller and Labán (1987) 74-81: 0,56 75-77: 0
82-85: 0,56-0,82 78-81:0,02
82-85: -0,09
Paredes and Riveros 0,25 (0,84) before 1979 reform
(1993) 0,75 (1,24) after 1979 reform
García (1995) 0,3 short run -0,03 short run
1,3 long run -0,1 long run
A recent effort closer to ours is that of Martinez, Morales and Valdés (2001)19 . They study the
possibility of structural changes in the demand for labor in the period 1986-2000 using quarterly
data. Their most relevant conclusion is that the labor demand output elasticity has not
significantly declined in the 1986-2000 period. The authors attribute the slow recuperation of
employment to the evolution of relative prices of the different inputs, in particular the cost of
capital. Even though the authors did not found a structural change in the period 1986-2000, they
do not reject the hypothesis of a possible structural change during 2000. Because of the lack of
data to test this, the hypothesis mentioned above is just stated. The output elasticity of the
demand for labor estimated for the long run is between 0.7 and 0.8 (0.25 for the short-run)
somewhat higher than for previous studies20 . Their real wages elasticity is estimated at –0,5
while the elasticity with respect to the cost of capital is 0,2.
The literature hence finds statistically significant although not very large output elasticities of the
demand for labour, in particular in the last part of the eighties. Well-defined prices (wages, cost
19
Another strand of researchers have concentrated more in micro issues concerning the labour market, such as
minimum wages, wage premiums, workers capabilities, education and training (Bravo and Contreras, 2000)
There has been also [considerable] research concerning the labour code, especially its comparison to other
countries (Mizala and Romaguera, 2001). Also related to this literature, there has been an in depth study
concerning poverty and distributive issues (World Bank, 2001).
20
This is probably due to the period chosen. Since 1986 and until 1998, the economy suffered almost no significant
deceleration and created jobs massively. Most of other studies, including this one, consider the 1975-83 period
which had a lot of job destruction.
31
of capital, real exchange rate) are also relevant in many econometric studies, although the
sensitivity of employment to real wages is on the low side. Let us now go in more detail to
estimate labor demand equations at an aggregate and sectoral level considering new analytical
and econometric issues highlighted by recent literature in this area.
3.1 Theoretical framework
Our approach starts from a simple labor demand equation derived from a profit-maximizing firm
subject to a budget constraint 21 . In such a framework we can derive a labor demand of the
following type:
ω
ln Ld = α + β ln Y + γ ln +µ (1)
p
where labour demand (Ld) is a function of output (Y) and average real wages (ω/p).
This model needs to be amended for a small open economy such as the Chilean economy: often
open economy models start with the recognition that good markets can be classified in two
groups, one concerning internationally traded goods and internationally non traded goods. All
the rest constant, the relative size of each market and hence the sectoral distribution of labour
will depend on the relative price between these two sectors, i.e., the real exchange rate, θ22 . One
should expect that a depreciated θ, that is a high relative price of the tradable good, should imply
that the output of the tradable good will be higher and hence labour demand in that sector will
also be increased.
A stylized fact highlighted in the literature is that the rate of growth of factor productivity in the
tradable sector is faster than in the non-tradable sector. This is the so-called Balassa-Samuelson
effect that is reflected in a secular trend towards a real appreciation of the exchange rate in a
growing small-open economy 23,24 .
21
See Hammermesh (1992) for a traditional textbook in the subject
22
We use the so called “latin american” definition of θ as relative price of the tradable good over non tradable
goods (see Edwards, 1988).
23
In Chile there is ample evidence of the presence of the Balassa-Samuelson effect (see the papers in Morandé and
Vergara, 1997).
32
However, in principle standard models consider that the real exchange rate should affect the
allocation of labour, not overall employment. One ammendment that can be introduced is within
the context of models with external constraints, where a permanent real depreciation has the
impact of alleviating that constraint and hence permitting an acceleration of growth for all
sectors in the economy, not just the tradable sector.
Another explanation for the effect of the real exchange on unemployment relies on some sort of
wage rigidity (for instance due to minimum wage regulation, insider-outsiders mechanisms; for
other causes see Lindbeck (1983)). In a model without wage rigidities, one could expect that as
one sector contracts as a result of a change in θ, the other sector will expand its labour demand at
a similar pace hence leaving overall employment constant (although with a different equilibrium
real wage). When there is wage rigidity, labour released in one sector will not be absorbed pari
passu in the sector expanding thereby generating unemployment. A similar result could obtain if
there are other institutional rigidities that impede a full sectoral reallocation of labour such as
institutional arrangements embedded in the labour code or when labor skills among sectors differ
significantly25 .
Tradable sectors are affected by external shocks and this can be a source of unemployment
fluctuations. One typical external shock is the terms of trade shocks that affect directly
employment in the tradable sector by changing the mix of employment in the exportable sector.
Economy-wide, a terms of trade deterioration leads to a fall in national income and aggregate
demand therefore reducing aggregate employment. There are also indirect effects in terms of
trade shocks because these shocks affect θ, the real exchange rate26 which leads us to our
previous discussion.
24
This argument implies that the sign of the elasticity of the real exchange rate to growth is not well defined. In
short term demand inspired models, the link is negative in the case of Chile. In long term growth accounting
models, there is almost no link. A sectoral decomposition of growth shown in Larrain and Larrain (2002) it is
found that the real exchange rate is significant and the sign is positive for trade and construction
25
Mizala and Romaguera (2001) analyse the evolution of the labour legislation in Chile since 1975. They argue
that the reforms made in the 1970s and 1980s gave considerable flexibility to the labour market but they probably
lacked social acceptance. Reforms in the 1990s have basically maintained significant flexibility but have focused
on attaining legitimacy by the labor movement.
33
3.1.1 Data and econometric strategy
Let us turn now to the empirical analysis. We use annual data for Chile starting in 1960 and until
2000. The overall and sectoral employment figures were already described in the previous
section. The macroeconomic series used include data of overall and sectoral GDPs from
National Accounts. The multilateral real exchange rate used is the one calculated by the Central
Bank of Chile for an ample set of trading partners. The terms of trade are constructed using
Central Bank data on export and import deflators (including both goods and services).
A variable measuring distortions and instability in the foreign exchange market relevant in
several sub-periods of our sample is the black market premium. Let us incorporate several
variables, besides real wages and output, that can affect employment.
3.1.2 Labor market flows of entry and exit. Extended Model
In order to control for the institutional arrangements that can create the same sort of different
response in the sectoral employment and that can create aggregate effects we construct a variable
measuring labour market flexibility. We use data from the Employment Survey of the University
of Chile27 concerning entry (E) to and exit (S) from unemployment. We then define a gross
measure of labour market flexibility as
E +S
φg ≡
U (2)
were U measures unemployment. This variable is “gross” in the sense that it is highly influenced
by the business cycle, something that we want to have explained within the model. Hence, we
run the following regression
φg = a + b dln GDP + c dlRER + e dln ω/p + ξ (3)
We obtain the following result
26
This is well documented in Edwards (1988) and De Gregorio and Wolf (1992) for an ample set of countries. For
Chile see Larrain (1996) and the papers included in Morandé and Vergara (1996)
27
A shortcoming of this survey, available since 1959, is that it only considers information for Greater Santiago.
34
Table 13
Estimation results for φ g
Parameter Estimate t Test

b 1.86 2.43
c -0.88 -2.64
d -0.46 -3.04
R2-adj 0.37
Dw 1.87
The error term in this regression, ξ, is by construction orthogonal to the business cycle and
relative price movements. We hence define the “net” measure of labour market flexibility φ n
simply as ξ. This variable is shown in the following graph.
Figure 2.2: A Net Measure of Labour Market Flexibility
60
40
20
-20
-40
-60
60 65 70 75 80 85 90 95 00
FLEXURES
3.1.3 Cost of Capital
To have a wider definition of factor prices we follow Martinez, Morales and Valdés (2001),
including as explanatory variable in the labor demand equation the cost of capital. We follow
them defining the cost of capital as
35

ρ (k ) − ρ (k )  
e

c t
=

rt + δ − t + 1
ρt (k )
t
×  1
 
− τ t f t  ρ t (k )
  ( 4)
Where ct is the cost of capital, rt is the UF indexed loan rate from 90-360 days, δ an annual
depreciation rate of 10%, τ is the corporate tax rate, and [pet+1 (k)-pt (k)] / pt (k) is the expected
capital gain. At last, f is the tax exemption given to the firms when they finance inversion with
debt. We assume f=1. Given that there are no series for interest rates before 1975, we can
compute this variable only since that date. This variable has the following shape.
Figure 2.3: Estimated Cost of Capital
0.30
0.25
0.20
0.15
0.10
0.05
60 65 70 75 80 85 90 95 00
KCOST
3.1.4 Recessions and Reform Policies
To capture the effects of major shocks and reforms that could have implied significant changes in
parameters we used a battery of dummy variables. As documented in the previous section of the
paper, the period 1960-2000 in Chile is characterized by structural changes and large external
shocks. The most critical dates that define different possible dummies to be tested Chow tests
are the following:
36
i 1971-1973, the period under the Unidad Popular government characterized by heightened
political confrontation and [non-market] economic policies. This dummy is called DUP.
ii 1975, in that year the Chilean economy suffered the combined the effects of a drastic fiscal-
based, anti-inflationary program along with a sharp increase in the international price of
oil,(the so-called OPEC-I) with the ensuing deterioration in terms of trade. As a consequence
of all this Chile suffers a major recession characterized by a steep decline in GDP, aggregate
employment and an increase in open unemployment. The dummy variable is D75
iii 1976, when the military started to implement profound structural changes. The dumming
called D76. This date is corroborated by both traditional Chow Tests for structural change.
iv 1979, a major change in the Labour Code took place. Dummy D79
v 1982-1983, a major currency and banking crisis takes place along with a worsened external
environment that led to massive output and employment decline. The dummy variable is
D8283
vi 1990, this represents a change in the political regime in Chile when democracy was
recovered, proxied by the variable D90. According to Jadresic and Zahler (2000) the
recuperation of civil rights played a significant role in explaining the high growth period that
took place during most of the nineties. Of course, the single year 1990 may actually hide the
fact that during about two years a different sorts of policies reshaped the economy, including
an important change to the Labour Code that started to be discussed in 1990 but which was
formally converted into Law in 1992.
vii 1999, the most recent recession in Chile (year of negative growth). Dummy D99
Alternatively the different recession periods can also be treated as group, defining DRES as all
the years in which the country suffered recessions following the above definition of dates.
3.1.5 The case of special employment programs
In 1975, the government created “special employment programs” designed to absorb part of the
unemployed caused by the recession and fiscal adjustment by offering transitory jobs in public
works to head of families and other unemployed workers. Those programs remained in
37
operation, at different scales, until 1988 and reappeared again under a different modality in 1999,
the last recession.
The following graph shows the evolution of emergency and (non-emergency) private
employment. In the empirical work, we shall not use total employment as a dependent variable
but only private employment and we shall ask which is the impact of special employment
programs on overall private employment. We denote it as “market employment”.
Employment and Emergency Programs in Chile
(Market employment in thousand people, left. Emergency programs as % of total employment, right)
4,500 25%
4,000
20%
3,500
15%
3,000
Market employment 10%

2,500 Emergency programs
5%
2,000
1,500 0%
80.I
81.I
82.I
83.I
84.I
85.I
86.I
87.I
88.I
89.I
90.I
91.I
92.I
93.I
94.I
95.I
96.I
97.I
98.I
99.I
00.I
Source: National Institute of Statistics
There is a potential problem of simultaneous causation here. On the one hand, employment
programs can eventually crowd-out private sector employment. On the other hand, emergency
employment programs have been created in response to a major decline in total employment,
including private sector employment. To test both hypothesis, we perform Granger-causality
tests using the same data but on a quarterly basis. The results are as follows:
38
Table 13
Granger Causality Test
Null Hypothesis: Obs F-Statistic Probability
EMP_PRO (*) does not Granger Cause PRI_SEC_EMP 82 0.83744 0.43672

PRI_SEC_EMP (**) does not Granger Cause EMP_PRO 16.0346 1.50E-06
(*) refers to employment programs
(**) refers to private sector employment
From this test we can conclude that the private sector employment Granger-cause the special
employment programs, therefore rejecting the hypothesis of crowding out of private employment
for emergency public works programs.
3.1.6 Unit roots
In order to decide the estimation technique we need to test the degree of integration of the
different series as we cannot simply mix variables with different degrees of integration. The
results are presented in Table 2.1 which basically tells that all series are integrated of order 1
(I(1)) at 1% confidence. The mining sector presents the more problematic case. In the case of
employment, the unit root appears only at 5% confidence level and in the case of wages it
appears only at 10%.
39
Table 14A
Unit Root Tests for Employment Series
ADF Test
Growth in Statistic Critical Value Status
Agricultural 0.3012 1% -2.6227 I(1)
Labour Level 5% -1.9495
10% -1.6202
Agricultural -4.1530 1% -2.6227 I(0)
Labour Growth 5% -1.9495
10% -1.6202
Manufacturing 0.8252 1% -2.6227 I(1)
10% -1.6202
Manufacturing -3.4968 1% -2.6227 I(0)
Labourg growth 5% -1.9495
10% -1.6202
Mining -3.0532 1% -3.6067 I(0) at 5%
10% -2.6069
Mining -5.1339 1% -2.6227 I(0)
10% -1.6202
Overall 3.1745 1% -2.6211 I(0)
10% -1.6201
Oveall -3.7871 1% -2.6227 I(0)
10% -1.6202
Table 14B
Unit Root Tests for Wage Series
ADF Test
Agricutural 0.2114 1% -2.6211 I(1)
Wage Level 5% -1.9492
10% -1.6201
Agricutural -6.1685 1% -2.6227 I(0)
Wage Growth 5% -1.9495
10% -1.6202
Manufacturing -2.1544 1% -3.6171 I(1)
10% -2.6092
Manufacturing -5.5187 1% -2.628 I(0)
10% -1.6206
Mining -2.7710 1% -3.6228 I(0) at 10%
10% -2.6105
Mining -4.2857 1% -2.628 I(0)
10% -1.6206
Overall -2.0521 1% -3.6019 I(1)
10% -2.6059
Overall -5.4279 1% -2.6227 I(0)
10% -1.6202
40
Table 14 C
Unit Root Tests for Output Series
ADF Test
Agricultural -6.6120 1% -3.6067 I(0)
Output 5% -2.9378
10% -2.6069
Manufacturing -5.1464 1% -3.6067 I(0)
Output 5% -2.9378
10% -2.6069
Mining -8.0223 1% -3.6067 I(0)
Output 5% -2.9378
10% -2.6069
Non Tradable -4.1493 1% -3.6067 I(0)
Output 5% -2.9378
10% -2.6069
Tradable -6.4563 1% -3.6067 I(0)
Output 5% -2.9378
10% -2.6069
Overall -4.5801 1% -3.6067 I(0)
Output 5% -2.9378
10% -2.6069
3.1.7 Other variables
As found in other studies mostly linked to the real exchange rate (see quotes before), the terms of
trade and the real exchange rate in Chile have unit roots, I(1). In its turn, the variables Black
Market Premium (measuring degree of macroeconomic instability) and Net Measure of Labour
Market Flexibility are I(0) whereas the Cost of Capital, in the period for which we have
observations has a unit root.
3.2 Results
3.2.1 Equations for aggregate employment
In table for aggregate we show our estimation results for aggregate employment. We find that
the most encompassing equations, 4 and 5, are co-integrated. Equations not including some of
the variables linked to any form of structural changes did not co-integrate. The reason is quite
obvious: co-integration means that there exists a stable long run relationship between a given set
of variables. If there is no control of the kind of structural changes that took place, then such a
long run relation cannot appear.
41
Table 15: Aggregate Labor demand equations 2829
Dependent Variable: log of total employment (excluding emergency employment programs).
Period: 1960-2000
Estimation procedure: Co integration (OLS for long run equation)
1 2 3 4 5
CONSTAN T 0.37 0.11 0.08 -1.26 -1.17

[0.79] [0.22] [0.17] [-2.00] [-1.89]
GDP 0.52 0.54 0.54 0.63 0.63
[8.56] [8.26] [8.55] [7.83] [7.78]
REAL WAGES 0.05 0.09 0.08 0.08 0.08
[1.73] [3.82] [3.57] [3.36] [3.38]
RER 0.25 0.29 0.28 0.32 0.32
[5.45] [6.14] [6.17] [4.99] [5.02]
EMPLOYMENT -1.42 -1.26 -1.16 -0.83 -0.82
PROGRAMS [-7.01] [-6.13] [-5.38] [-3.60] [-3.62]
TECHNOLOGICAL -0.21 -0.28 -0.28 -0.31 -0.30
PROGRESS [-1.89] [-2.37] [-2.42] [-1.86] [-1.82]
BLACKMARKET 0.01 0.01 0.01 0.02 0.02
PREMIUM [1.66] [2.66] [2.63] [3.12] [3.11]
FLEXURES 0.001 0.00
[2.10] [2.11]
GDP*DUMMY 75 -0.01
[-2.61]
RECESSION -0.07
74-75 [-2.26]
RECESSION -0.03
99 [-0.72]
ALL RECESSIONS -0.03
[-1.44]
DUMMY 75 -0.09
[-2.68]
DUMMY UP -0.12 -0.12
[-2.35] [-2.35]
adj R-Squared 0.989 0.987 0.988 0.987 0.987
The last two regressions, 4 and 5, are the best, both co integrate at 10% significance level. To see
if the equations are co integrated we use the Engle Granger test. The results are as follows
28
The dependent variables depurates emergency employment programs.
29
The technological progress is measured as rate of growth average labor productivity in G-7 countries.
42
Table 16
ADF Test for the residual of Equation 4
ADF Test Statistic Critical Value
residual -4.552769 1% -5.6748
5% -4.8728
10% -4.4843
Table 17
ADF Test for the residual of Equation 5
ADF Test Statistic Critical Value
residual -4.57202 1% -5.6748
5% -4.8728
10% -4.4843
The two selected equations may be enriched considering two facts. One is that co integration is
found only weakly, at 10% confidence. This means that some endogeneity problem could have
remained on the right hand side of the equations30 . Second, we have not yet described the short-
term dynamics of the equation. In order to complete the study of these two equations we use
alternatively a vector error correction approach, which allow us to obtain the co integration
vector and the error correction model.
Reestimating equation 4 in table 15 using a Vector Error correction model we obtain: (all
variables in log)
30
Recall that when there is cointegration between depedent and independent variables, Engle-Granger (1987) show
that the endogeneity problem does not matter.
43
Dependant Variable: log of total employment
(excluding emergency employment programs)
Period: 1960-2000
Estimation procedure: VEC
Log of Overall Output 0.58
47.52
Log of RER 0.43

10.15
Log of Real Wage -0.08

-4.69
Net Flexibility 0.00

2.59
Tech progress -0.21

-4.04
Log output*d75 0.16

5.07
D75 -2.59
-5.13
Adj. R-squared 0.65
Therefore, from this section we learn that the output elasticity of the aggregate demand labor is
around 0.6. This is a similar value to the average gross elasticities found for the 1960-2000
period obtained in section 2. Multiplicative dummies trying to explore changes in that variable
across time suggest that there was a fall in the labor absorption capacity of the economy after
1975. There is no evidence of a further reduction in labor intensity during the nineties.
Real wages appear always significant but with a very small parameter (fall in output-employment
elasticity), between –0.05 and –0.08. Hence, it seems unlikely that the huge increase in
unemployment after 1998 can be explained on the basis of an increase in the expected cost of
labour.
The real exchange rate appears always significant with a positive parameter even though it is
quite unstable fluctuating in the range 0.2 to 0.6. Partially this has to do with the fact that
comparing the sixties with the eighties and nineties both employment and the real exchange rate
increased. It could also have played a role the external constraint alleviation effect of the real
depreciation.
44
Technological progress in advanced economies displays a significant negative effect on labor
demand suggesting the presence of labor saving technical progress. The parameter fluctuates
around 0.23 and 0.3 and its stability suggests that this effect is probably not linked to specific
policies, for example trade openness.
The flows of entry and exit measuring labor market flexibility also appear to have a positive
impact on labor demand, even though the interpretation of the parameter cannot be readily
interpreted as a elasticity.
3.2.2 The Tradable Goods Sector
We now turn to the estimation results of the demand for labor in the tradable sector of the
economy. Table 18 shows the outcome.
Table 18
Dependent Variable: log of tradable employment
Period: 1960-2000
Estimation procedure: Cointegration (OLS for lon run equation)
Eq 1 Eq 2 Eq 3 Eq 4
Variable Coefficient t-Statistic Coefficient t-Statistic Coefficient t-Statistic Coefficient t-Statistic
Constant 2.75 2.45 5.48 2.89 6.71 51.90 6.15 15.66
Output of Tradables 0.29 3.04 0.10 0.67
Output of Tradables*d75 0.42 2.72 0.49 4.58 0.48 4.49
Log of real wage -0.01 -0.41 -0.01 -0.34
Log of real wage*d75 -0.13 -2.02 -0.12 -2.06 -0.11 -1.89
Log of RER 0.12 2.01 0.10 1.66 0.12 2.92 0.13 2.89
Net Flexibility 0.00 2.15 0.00 2.02 0.00 1.99 0.00 2.19
D75 -0.17 -3.36 -5.41 -2.63 -6.35 -5.00 -6.25 -4.88
D89 0.16 3.81 0.09 1.94 0.09 2.12 0.08 1.75
Log terms of trade 0.11 1.59
Adj R-Sq 0.910 0.928 0.932 0.935
The above equation shows several striking results:
• The output elasticity for the whole period is around 0.29 but when we consider the
impact of the 1975 structural change, we find that its significance only appear after the shock.
Before 1975, the estimated income elasticity is therefore null. After 1975 the income elasticity is
45
significant with a positive sign. The estimated parameter is 0.49 below the one estimated for the
whole economy in the previous section.
• Real wages did not appear to be significant for the whole period but after
controlling by the 1975 structural change we find a significant negative parameter of –0.12
• The Real Exchange Rate has a positive and significant sign even though the
estimated elasticity appears to be low compared with the one estimated for the aggregate
employment. This suggests surprisingly that the real exchange rate has a stronger impact over the
non tradable sector. One hypothesis that could explain this is that in this period the economy
could have suffered significant foreign external constraints that were levied by means of a more
depreciated real exchange rate.
• Flexibility of the labor market appears to be positively correlated with employment

in the tradable sector. The size of the parameter is smaller than that of the aggregate economy
• Beyond the changes in elasticities already mentioned, the 1975 structural change did
imply a significant downward shift in the labor demand schedule. In 1989 we find a statistically
significant, whereas smaller in absolute size, upward shift in the same schedule.
• The terms of trade variable appear to be only moderately significant with an

estimated elasticity of 0.11.
As a conclusion, the tradable sector displays a lower-than-the-average ability to create jobs per
unit of output (confirming the findings of section 2A) while a superior-than-the-average
sensibility to real wage movements. As predicted by theory, the demand for labor in this sector
is sensitive of the real exchange rate but its elasticity is low compared to the aggregate
corresponding elasticity of employment.
3.2.3 Manufacturing Sector
The manufacturing sector is one of the most important sectors within the tradable sector of the
economy. Table 19 shows the final equation estimated for this sub sector.
46
Table 19
Dependent Variable: log of manufacturing employment
Period: 1960-2000
Variable Coefficient t-Statistic

Constant -3.67 -3.98
Log Manufacturing Output 0.84 8.70
Log Real Wage Manuf. -0.04 -1.05
Undervaluation 0.48 5.09
Net Flexibility 0.00 1.48
Black Market 0.02 2.53
Tech Progress -0.21 -2.38
D89 0.13 3.33
Adj. R-Sq 0.965
The result obtained also shows strinking features:
• The output elasticity of employment in the manufacturing sector is relatively high,

0.84 far above the one estimated for the aggregate economy or the tradable sector as such.
Further, there are no signs of instability of this parameter.
• Manufacturing real wage does not appear to be statistically significant at any

moment in time.
• The real exchange rate did not appear to be significant but the degree of under
valuation of the domestic currency appear both statistically significant and with a sizeable
coefficient.
• Flexibility appears marginally significant if we use as a criterium the t-statistic but

nevertheless if we drop it from the equation both the adjusted R-Sq suffered significantly and the
traditional AIC parameter also suggested to keep the variable in the final equation.
• The black market premium appears significantly and positively correlated with
manufacturing employment, a surprising result.
47
• Labor saving technical progress is significant and its elasticity is stronger than the
one found for the aggregate economy
• The only significant dummy variable is that of 1989. There is no multiplicative

dummy variable that appears significant.
3.2.4 Agricultural Sector
The final result for this sector is shown in Table 20
Table 20
Dependant Variable: log of agricultural employment
Period: 1960-2000
Constant 2.63 7.07
Log of Agricultural Output 0.24 5.00
Log of Agricultural Output*d75 -0.02 -5.76
Log of Real Wage Agr. 0.06 1.95
Log of RER 0.25 4.44
D67 -0.15 -5.63
Adjusted R-squared 0.906
The outcome reflects some specificities of this sector:
• The output elasticity is significant but well below the economy wide average. This
elasticity declined somewhat with the openness of the economy in 1975 and since then there is
no evidence of further changes.
• Surprisingly, we obtain that the agricultural real wage elasticity is positive. We do

not have a clear explanation for such a result.
• The agricultural employment appears to be positively affected by the real exchange

rate. This can be expected as a tradable goods activity.
48
• Also this sector is affected positively by net flexibility in labor market.
• Instead of the D75 variable which has been significant for other sectors, in the case
of the agricultural sector the relevant variable is D67, which is linked to the agrarian reform
process taking place in those years.
3.2.5 Mining Sector
Mining employment is affected, as shown in Table 21 where many variables appear in the final
equation, by several factors.
Table 21
Dependant Variable: log of mining employment
Period: 1960-2000
Constant 4.14 3.48
Log of Mining Output 0.14 1.15
Log of Mining Output*d90 0.00 0.26
Log of Real Mining Wage -0.06 -3.52
Log of RER 0.19 3.13
Tech progress -0.45 -3.42
Black Market 0.01 2.83
Log Terms of Trade 0.12 3.26
D89 0.15 3.84
D8283 -0.12 -4.43
Adj. R-Sq 0.863
Indeed, as the rest of the sectors, the output elasticity in mining is positive but significantly
smaller than the one found for the other tradable goods sectors. That elasticity became slightly
higher since 1990. In its turn, the real wage appear statistically significant and with the expected
sign. The estimated wage elasticity is close to the average of the economy reported previously.
The real exchange rate is also important in determining the mining employment. Flexibility
shares the same characteristics of the previous sector: despite having low t-tests, information
49
criteria suggests to include it in the final equation. Technical progress appears also with strong
significance and the elasticity is considerable. Once again, the black market premium appears
significant while with the opposite sign. The terms of trade are significant and with a small
elasticity. The labor demand schedule in the mining sector suffered a positive shift in 1989 and a
negative shift in the 1982-83 crisis.
3.3 Empirical Analysis of Unemployment.
This section takes a more detailed look at the behavior of current unemployment in the last four
decades and then presents an econometric analysis of its determinants. As mentioned in section
2.A the 1960s and 1990s, present relatively low and stable unemployment rates in contrast with
the 1970s and 1980s in which unemployment rates where high and volatile. In addition, in the
last four decades there are two periods in which the unemployment rate exceeded 9 percent, a
value that can be considered as “high”: 1974-1988 ( a period of 15 years) and the period 1999-
2001. Years in which unemployment was particularly high were 1975- 79 and 1982-87
associated, respectively, with the big recessions of 1975 and 1982-83 (See table 22). If we add
the rate of open unemployment plus employment in the emergency programs, as a share of the
labor force,(column 2 and Table 22) the sum exceeds 24 percent between 1982 and 1984. In the
period 1999- 2001 the rate of unemployment averaged 10.2 percent.
50
Figure 7.
CHILE. Unemployment Rate
1960-2000
35.0
30.0
25.0
20.0
15.0
10.0
5.0
0.0
Years
Open Unemployment Rate Unemployment Rate Including Employment Emergency
3.3.1 Empirical Unemployment Equations
Let us turn now to the estimation of an empirical unemployment equation be with annual data for
the period 1960-2000. A simple semi-reduced form is provided in equation below. This
equation is an expanded Phillips curve equation solved for the current unemployment rate in
which the determinants are31 :
• The rate of inflation.
• An indicator of macroeconomic slack (excess supply in the goods market).
• An indicator of the rate of growth of labor productivity (proxy for technical change).
• A persistence term (lagged unemployment) intended to capture possible path-

dependence or hysteresis effects in which past unemployment affects current unemployment.
31
See Blanchard (2000) for analytical underpinnings of unemployment models.
51
• A set of dummy variables capturing recessions (years of negative growth) of the
period 1960-2000 and the main structural reforms of the period.
The rate of unemployment is measured as the rate of open unemployment; the rate of inflation is
measured as the annual rate of change in consumer price index (actual current and lagged
inflation rates were tried in the regressions as well as surprise inflation)32 . The ratio of current
GDP to potential GDP (the later measured through the peaks method, see table 24) a measures of
the degree of macroeconomic slack (or excess supply in the goods market). The aggregate rate
of growth of labor productivity is measured as the rate of change in the ratio of aggregate
employment to GDP. The recession dummy captures the years 1975, 1982-83 and 1999.
µ = α + βπ + δϕ + γρ + η µ −1 + λd 75 + υd 8283 + ψd 99 + ε (5)
were α , β , δ , γ ,η , λ ,υ ,ψ are parameters to be estimated, µ is the rate of unemployment, π is the
rate of inflation, ϕ is the output gap, ρ is the rate of growth of labor productivity, µ −1 is the rate
of lagged unemployment, d75, d82-83 y d99 are recession dummies that take the value 1 for
1975,1982-83, and 1999 and ε is a random term. Unemployment equation (5) is estimated by
Ordinary Least Squares with annual data for 1960-2000. In general, the quality of the fit of the
regression is good with R-squared over 85 percent in the more complete specifications of table
2333 . In general the main results obtained can be summarized as follows:
a) Lagged unemployment is statistically significant in various specifications suggesting

the existence of persistency effects in unemployment. Path dependence and hysteresis effects are
thus present in explaining current unemployment in Chile. The literature (see Lindbeck, 1993
and Layard and Calmfors, 1987, Malinvaud, 1984) highlights several mechanisms behind
unemployment persistence (in which past unemployment affects current unemployment): these
mechanisms are capital shortage, destruction of skills and human capital capacities during
32
“Surprise inflation” is measured as the difference between actual inflation and a smooth-inflation series
constructed through the Hendrik-Prescott filter.
33
Autocrrelation is tested through the H-Durbin- Watson statistics.
52
protracted recessions, lower job search efforts by discouraged workers after long-spells of
unemployment, labor turnover costs. A fuller investigation of the relative importance of each
mechanism still remains to be done likewise an econometric analysis of the natural rate of
unemployment.
Figure 8
CHILE. Output Gap and Open Unemployment
25.0
20.0
15.0
10.0
5.0
0.0
-5.0
Years
Output Gap Open Unemployment

Rate
b) The output gap has a positive and significant effect in the different specifications (see
table 23). Also figure 8 shows that the unemployment rate tracks closely the behavior of the
output gap, suggesting a close correlation between slack (excess supply in the goods market) and
the rate of unemployment (excess supply in the labor market).
c) The recessions dummies are very significant, highlighting the importance of large
recessionary shocks in generating jumps in the unemployment rate.
d) The current inflation rate and “surprise inflation” are not found statistically significant
at 95 % confidence levels. Lagged inflation has a positive coefficient. In contrast Phillips curve
equations and other models would suggest a negative effect of inflation on unemployment.
However, the observed positive effect of lagged inflation on unemployment34 may reflect the fact
in our sample period the years of high inflation also coincide with the years of high
34
A similar effect is detected in Marcel and Solimano (1994).
53
unemployment, particularly during the 1970s and during the crisis of 1982-83 in which a sharp
rise in unemployment came along with some acceleration in inflation.35
TABLE 23
CHILE. Dependent Variable: Unemployment Rate,
1960-2000
[1] [2] [3] [4] [5] [6] [7]
Constant 1.57 1.09 2.53 2.47 2.37 1.94 1.54

[1.71]* [1.28] [3.42] [3.05] [3.01] [3.23] [2.59]
Lagged 0.83 0.82 0.53 0.523 0.54 0.56 0.61

Unemployment [9.27] [10.13] [5.94] [5.58] [5.37] [7.33] [8.04]
Lagged 0.01 0.002 0.002 0.002 0.005 0.006

Inflation Rate [2.97] [1.03] [0.92] [0.74] [2.39] [2.94]
Output Gap [a] 0.29 0.316 0.297 0.19 0.14

[4.70] [4.70] [3.39] [2.90] [2.16]
Average Labor 0.034 0.037 0.16 0.16

Productivity [b] [1.24] [0.39] [2.16] [2.20]
Recession 75 1.51 3.50 4.01

Dummy [c] [0.71] [2.13] [2.55]
Recession 82-83 6.10 6.53

Dummy [c] [5.08] [5.67]
Recession 99 2.87
Dummy [c] [2.18]
R-Squared 0.69 0.75 0.85 0.85 0.85 0.91 0.93
h (D-W) 1.64 0.39 2.61 2.61 2.70 0.18 -0.68

Number of
Observations 39 39 39 39 39 39 39
Method of estimation: OLS

Values under parenthesis correspond to t-student
[a] Output gap = [1 - (y/y*)]*100, where y* is potential GDP,
[b] Average Labor productivity is the difference between GDP growth rate and unemployment growth rate.
[c] Recession dummy takes values 1 for 1975, 1982-1983 and 1999 and zero otherwise.
35
It would be interesting to estimate the relationship between inflation and unemployment at low inflation levels (a
flat Phillips curve) such as in the late 1990s, and early 2000s.
54
TABLE 24
µ is the rate of open unemployment. Source: National Bureau of Statistic of Chile.
π is the rate of Consumer price inflation. Source: National Bureau of Statistic of Chile.
ϕ is the output gap. Output gap = [1 - (y/y*)]*100, where y* is potential GDP.
y* is the potential GDP is measured through the peaks method. Source: Ffrench-Davis (2001,
capítulo I).
ρ is the rate of growth of aggregate average labor productivity (rate of growth of GDP less the
rate of growth of employment. Source: Central Bank of Chile and National Bureau of Statistic of
Chile).
Figure 9
CHILE. Unemployment rate Actual and Fitted
25
20
15
10
Years
Unemployment rate Unemployment Rate Fitted
55
4 Synthesis and Concluding Remarks
The paper puts the post-1998 recession cum sluggish growth cycle in comparative perspective of
previous recession and recovery cycles of the Chilean economy such as the large recession of
1975 and the currency and banking crisis of 1982-83 and other milder-intensity cycles. The
paper shows that large recessions in the past have been followed by a relatively long process of
recovery in which output takes around 3-4 years to recover their pre-crisis levels; in turn, the
speed of recovery of employment and real wages and the decline in unemployment is often
slower than the recovery of output. A stylized fact of all large cycles of the Chilean economy in
the last 30 years is the existence of considerable unemployment persistence after large
macroeconomic shocks.
The paper examines several hypothesis put forward to explain the weak recovery of employment
in 2000-2001 after the recession of 1999. The role of weak aggregate demand, the stance of
fiscal and monetary policy, the possible disincentive effect of changes in labor legislation, the
effects of restructuring in recessions, the adverse effect of protracted slowdowns on the rate of
expansion of productive capacities are discussed in the paper. A combination of weak domestic
spending associated with a largely ineffective monetary policy and an almost neutral fiscal policy
seem to have contributed to a still weak recovery of output and employment in the aftermath of
the 1999 recession. The impact of labor legislation and the importance of the “cleansing effects”
of recessions are still open questions in terms of their quantitative impact on employment and
output.
This paper also looks at medium to long run trends in the capacity of employment generation of
the Chilean economy. The gross output–employment elasticities for the period 1960-2000 show a
lower output –employment elasticites in the 1990s than in the 1990s; this elasticity starts to
decline since the mid 1970s. In addition, it also appears a tendency in the Chilean economy to
stabilize at higher unemployment rates than its historical levels, even when the economy is
growing very rapidly as it occurred in the 1990s (until 1998). This reflects the high persistence of
unemployment rates, detected also in our econometric analysis.
The paper also documents that the output-elasticity of employment in the non-traded goods
activities is significantly higher than the output elasticity in the traded goods sector. The main
56
engine of growth of the Chilean is export development and the promotion of the traded goods
sector but the direct capacity of generating employment of the traded goods sector is not high.
The econometric analysis of the paper estimates labor demand equations for the aggregate and
for manufacturing, agriculture, mining and the non-traded goods sector with annual data for the
period 1960-2000. Existing estimates are reviewed and new estimates are provided. The main
findings are:
(a) there is a clear structural change in 1975 for overall employment: at the same time the
labor demand schedule shifted downwards, and the economy lowers its labor intensity per unit of
output, resulting in a relatively “labor-less growth path”. The non-traded goods sector in general
has higher output-employment elasticities than the traded goods sector. Within tradables, mining
has a very low output elasticity of employment and agriculture has been steadily reducing its
contribution to aggregate employment since the 1960s. The main structural change found for the
demand for labor in the agricultural sector appears in 1967 around the time of the agrarian
reform. In the econometric estimates we find no evidence of a change in these patterns during the
nineties.
(b) the labor demand schedules are quite inelastic to real wages, particularly in the short
run; these elasticities have changed over time in the last 40 years but often around although
moderate values.
(c) in the long run, real exchange rate depreciations seem to have a positive effect on
aggregate employment; at sectoral level they have a significant impact in the employment mix
between tradable and non-tradables.
(d) The flows of entry and exit in the labor market, corrected by cyclical factors, have
been considered as a measure of labor market “flexibility” and seem to be also a significant
positive determinant of employment.
Empirical unemployment equations are estimated econometrically with annual data for the 1960-
2000 period. An augmented Phillips curve model is estimated to include persistence and path-
dependence effects after controlling for recessions, technical change and reform policies. The
empirical results show that:
57
a) current unemployment exhibits strong path dependence. This lends support to the
observed fact that unemployment is slow to decline after large recessive shocks and that is
sensitive to a fast recovery in output. Path dependency tends to generate a tendency for
unemployment persistence on account of several mechanisms: shortage of productive capacities,
destruction of skills in recessions, labor turnover and discouragement effects of workers in search
activities.
b) Aggregate unemployment is closely related to macroeconomic slack and is very

sensitive to large negative shocks coming from external sources and/or related to restrictive
monetary and fiscal policies.
Finally and looking at the future, for the Chilean economy to get out of its current trap of
unemployment, sluggish growth and pessimistic expectations and stabilize at a high employment
equilibrium it needs to ensure a steady path of rapid growth, able to deal with large shocks that
destroy jobs and create resilient unemployment. Monetary policy has to be conscious of its
potential to destroy jobs when pursuing excessively tight anti-inflationary objectives as it
happened in the recent past. In a democratic society, anti-inflationary goals need to be balanced
by the economic authorities with the objectives of full employment and steady growth.
Macroeconomic policies need to be complemented in creative ways by other policies to increase
employment through labor intensive activities such as the segment of small and medium scale
enterprises, to promote public investment in labor-intensive infrastructure and the need of having
adequate labor markets institutions that have social consensus.
58
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Draft From Economic Miracle to Sluggish Performance: Employment,

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From Economic Miracle to Sluggish

Performance: Employment, Unemployment and Growth

Andrés Solimano Guillermo Larraín

2. Output, Employment and Unemployment in the Period 1960-2001

2.1 Medium and Long Run Trends

2.2 Economic Cycles: Big Recessions and Downturns.

3.1 Theoretical framework

3.2 The Demand for labor: Estimates for 1960-2000

3.3 Empirical Unemployment Equations

Problems of unemployment and difficulties in employment generation were largely absent in

2 Output, Employment and Unemployment in the 1960-2001 Period

2.1 Medium and Long Run Trends

Regarding unemployment, we seem to be in presence of a significant shift in the unemployment–

[1] [2] [3] [5]

1960-70 4.26 6.50 5.46 2.37

1960-00 4.22 9.29 2.48 2.00

[1] [2] [3] [4]

Rate of change % Rate of change % Rate of change %

1960-70 1.76 1.90 4.26 0.44

1960-00 2.23 2.21 4.22 0.52

1960-70 11.9 25.7

1960-00 23.4 32.8

1960-00 0.52 0.23 0.71

Female Participation in the Labor Force

Cycle [1] [2] [3]

Rate of change % Rate (1970=100)

Before and after

Before and after

[1] [2] [3]

Recession of 1975 3 years - 4 years

Recession of 1982-83 4 years 4 years 5 years

Source: Author's ellabor.

[1] [2] [3]

[1] GDP growth rate.

Source: Author's ellabor.

Open Unemployment Rate

2.3 The Post-1998 Period: Sluggish Growth and Higher Unemployment

2.3.1 Macroeconomic background

2.3.2 Employment Adjustment between 1997 and 2001

Source: National Institute of Statistics (INE)

Minimum Wages in Chile, 1990-2002

Gross Fixed Capital

Source: Central Bank of Chile

Source: own elaboration based on ILO data.

3 The demand for labour in Chile: Econometric Estimates for 1960-2000

Previous estimates in the literature of elasticities for labor demand

3.1 Theoretical framework

3.1.2 Labor market flows of entry and exit. Extended Model

φg = a + b dln GDP + c dlRER + e dln ω/p + ξ (3)

We obtain the following result

Estimation results for φ g

Parameter Estimate t Test

Figure 2.2: A Net Measure of Labour Market Flexibility

3.1.3 Cost of Capital

Figure 2.3: Estimated Cost of Capital

3.1.4 Recessions and Reform Policies

3.1.5 The case of special employment programs

ϕ is the output gap. Output gap = [1 - (y/y)]100, where y* is potential GDP.