The Dynamic Effects of State-Dependent Labor Adjustment Cost : Evidence from Brazil’s FGTS Policy

The most recent recessions in Brazil pose a challenge for current business cycle models due to a key piece of legislation that causes labor to adjust in unconventional ways. We propose a two-sector model that resembles the formal and informal sectors in Brazil. While the formal sector is subject to a termination penalty inspired by said legislation, the informal sector makes labor decisions in a frictionless environment. Our model accurately predicts that recessions preceded by long expansions impact labor levels more severely than downturns following shorter economic booms. Importantly, the state dependence property of our legislative adjustment cost allows us to replicate the delay between the beginning of an economic downturn and the trough in the formal-sector labor level, a unique feature observed after the 2014-2016 depression in Brazil