The Macroeconomic Dynamics of Labor Market Policies

Abstract

We develop a dynamic macroeconomic framework with worker heterogeneity, monopsony power, and putty-clay adjustment frictions in order to study the distributional impact of labor market policies in the short and long run. Our model helps reconcile the tension between low short-run and high long-run elasticities of substitution across inputs of production. We use the model to assess the labor market effects of redistributive policies such as the federal minimum wage and the Earned Income Tax Credit (EITC). A key result of our analysis is that measuring the welfare impact of these policies requires taking into account the entire time path of the responses they induce. For instance, either increasing the minimum wage or expanding the EITC makes low-wage workers better off in the short run. However, the effects of the two policies can substantially differ in the long run. At longer horizons, both small minimum wage increases and EITC expansions of any size continue to make low-wage workers better off, whereas sufficiently large minimum wage increases adversely impact such workers. We find that combining either the EITC or the overall tax and transfer system with moderate increases in the minimum wage better supports the income and welfare of low-wage workers than either policy does in isolation, because doing so more effectively offsets firms’ monopsony power. We conclude by discussing the conditions under which empirical estimates of the short-run effects of labor market policies are informative about their ultimate long-run effects through the lens of our model.