Employment and firm heterogeneity, capital allocation, and countercyclical labor market policies

Developing and emerging economies have large employment shares in micro and small firms, which are characterized by limited access to formal financing and high reliance on input credit. These economies implemented a host of countercyclical labor market policies amid the Global Financial Crisis (GFC), but labor market data limitations prevent detailed empirical assessments of the effectiveness of these policies. We develop a business cycle model with frictional labor markets consistent with the employment and firm structure of these economies and assess the aggregate impact of key countercyclical labor market policies implemented amid the GFC. Improving job intermediation for large firms is particularly effective in aiding recoveries. Policies targeting smaller firms yield limited aggregate benefits. Differences in labor productivity and sectoral contribution to employment and output across firm categories are key in explaining the response to policy.