Kamel Ismail Project

Modelling the 2017 Salary Scale in Lebanon: A
Search and Matching Approach

∗
Kamel Ismail
June 2019
Abstract
I use a two-sector search and matching model in order to study
the effects of a public-sector-based employment stimulus program in
Lebanon. Results show that a permanent deterministic shock on pub-
lic vacancies and wages crowds out the labour market raising by that
unemployment. This result holds when the TFP shock is positive and
is amplified when the economy is subject to a negative temporary TFP
shock. Most of the crowding out is caused by the increase in public
sector wages. These results clearly indicate that given the tax policy
in Lebanon, a government-based employment stimulus program is in-
effective and can even be harmful.
∗
I take this opportunity to thank Professor Julien Albertini without whom this work
would not have been possible. I would also like to thank all the Professors for this enriching
academic year. I dedicate this work to my parents and my brother.
1
Contents
1 Introduction 3
1.1 Literature Review . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2 Research Paper Framework and Results . . . . . . . . . . . . 7
2 Lebanon’s Economic Environment 10

2.1 Lebanon’s Financial Situation . . . . . . . . . . . . . . . . . . 10
2.2 Lebanese Labour Market Facts . . . . . . . . . . . . . . . . . 10
3 The model 12
3.1 General Setting . . . . . . . . . . . . . . . . . . . . . . . . . 13
3.2 Households . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
3.3 Workers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
3.4 Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
3.5 Nash Bargaining and Private Sector Wage Determination . . 19
3.6 Government . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
3.7 Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
4 Calibration 22
5 Results 24
6 Conclusion and Discussion 32
References 34
7 Appendices 36
7.1 Steady State Tax Level Variation . . . . . . . . . . . . . . . . 36
7.2 Steady State Public Sector Wage Premium Variation . . . . . 37
7.3 Steady State Public Sector Matching Efficiency Variation . . 38
7.4 Steady State Bargaining Power Variation . . . . . . . . . . . 39
7.5 Transition Path of the Economy in Response to a Permanent
Deterministic Shock on Technology, Public Employment and
Public Wages . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
Deterministic Shock on Public Employment and Public Wages 41
Deterministic Shock on Public Wages . . . . . . . . . . . . . 42
Deterministic Shock on Public Vacancies . . . . . . . . . . . . 43
Deterministic Shock on Technology . . . . . . . . . . . . . . . 44
1
7.10 Transition Path of the Economy in Response to a Determin-
istic Temporary Shock on the Total Factor Productivity . . . 45
7.11 Transition Path of the Economy in Response to a Tempo-
rary Deterministic Shock on the Total Factor Productivity
Augmented by a Permanent Deterministic Shock on Public
Vacancies and Wages . . . . . . . . . . . . . . . . . . . . . . . 46
7.12 Transition Path of Unemployment in Response to Different
Shocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
7.13 Transition Path of Private Sector Employment in Response
to Different Shocks . . . . . . . . . . . . . . . . . . . . . . . . 48
7.14 Transition Path of Public Sector Employment in Response to
Different Shocks . . . . . . . . . . . . . . . . . . . . . . . . . 49
7.15 Transition Path of Private and Public Employment as well as
Unemployment in Response to a Negative TFP Shock . . . . 50
2
1 Introduction
1.1 Literature Review
Previous neoclassical models failed to replicate fluctuations in hours worked.
Labour supply in these models is determined via utility maximization while
labour demand is determined via profit maximization. The intersection
of labour supply and labour demand determines equilibrium wages. This
prevents neoclassical models from predicting unemployment, and thus the
extensive margin of labour supply.
On the other hand, search and matching models, succeed in taking un-
employment into account, thus, better explain fluctuations in hours worked.
This is done by introducing frictions in the labour market. Such that; unem-
ployed workers need time to find a job and vacancies are not filled instantly.
Moreover, wages are no longer determined in a centralized market but via
bilateral bargaining.
Moreover, worldwide, compensations to employees occupy a significant

amount of public expenditures. Thus, an important body of the literature
started to model public expenditures as compensations to the public sec-
tor employees rather than the purchase of goods from the private sector.
Public employment represents a major driving force in the labour market.
In OECD countries, public employment rate attained 21.3% in 2013. This
combination of the substantial size of the labour force and the sizeable share
of public expenditures makes public sector employment a major force in the
transmission of fiscal policies.
The rationale behind adopting this new approach when dealing with
public expenditures lies in the fact that shocks to government purchases
and government employment do not have the same effects on the economy.
A positive government purchase shock results in increased investment, em-
ployment and output i.e. the shock is an expansionary impulse. While a
positive public vacancies shock is a contractionary impulse due to the crowd-
ing out effect.
Numerous studies have considered compensation to employees as the

main component of governments’ expenditures. These can be divided into
two categories, frictionless labour market models and search and matching
models.
1. Frictionless Labor market models:

Finn (1998) uses a Real Business Cycle model for the U.S. economy
in order to study the effect of public spending on the business cy-
3
cle. He considers a perfectly competitive labour market and divides
government spending into two components:
(a) Purchase of final goods and services. This represents the ap-
proach used in the traditional Keynesian IS-LM models and other
RBC models1 .
(b) Compensation to employees.
The paper finds that an increase in public employment increases un-

employment and reduces output and investment. On the other hand,
an increase in the public purchase of final goods and services has the
opposite effect. The paper also shows that due to arbitrage, public
sector wage has to equate the one in the private sector.
Algan, Cahuc, and Zylberberg (2002) built a labour market model
with private and public sectors. They find that the crowding out ef-
fect increases when the two sectors are substitutable as well as when
the public sector provides higher salaries and more attractive oppor-
tunities.
Ardagna (2007) used a dynamic general equilibrium model with a
unionised labour market. The model predicts that a debt-financed
increase in the public purchase of goods crowds out private consump-
tion and has no effects on the supply-side of the economy. On the
other hand, an increase in public employment, public sector wages,
unemployment benefits and labour tax increases labour costs and dis-
courages firms from hiring.
2. Search and matching models with the public sector :

The search and matching framework was first introduced by Diamond
(1982), followed by Mortensen (1982), Pissarides, Jackman, and Savouri
(1990). These models exhibit matching functions that link unemploy-
ment and vacancies to the production of new matches. A bargaining
procedure distributes the match surplus between workers and firms.
Unlike the neoclassical theory of labour market where; labour supply is
determined via utility maximization, labour demand is determined via
profit maximization and wages are determined via the market clearing
condition, the search and matching approach accounts in its study for
unemployment i.e. the extensive margin of labour supply. Therefore,
it can better explain fluctuations in hours worked, especially that, the
neoclassical approach only considers the intensive margin of labour
supply.
1
Both of these models finds that an expansion in the purchase of goods invokes an
expansion in employment and output. However, each of the two models explains this
increase through different mechanisms.
4
Quadrini and Trigari (2007) studied the effect of public sector em-
ployment on the private sector labour market. This was done by con-
structing a basic search and matching model where the private sector
employment is determined through profit maximization and private
sector wages are determined through Nash bargaining. In their model,
the government follows an exogenous rule for public wages and employ-
ment. They find that due to the higher wage premium in the public
sector and reduced job creation in the private sector, acyclical public
sector wages amplify the magnitude of negative shocks by crowding
out private sector jobs. The authors also show that procyclical em-
ployment reduces business cycle volatility due to crowding out effect
generated by the large public sector employment.
3. Pappa (2009) adds on the paper of Finn (1998) by allowing for nominal
rigidities. The model accommodates an unproductive government con-
sumption, a productive government investment as well as government
employment disturbances in both RBC and New Keynesian models.
The paper shows that in an RBC framework, shocks on government

consumption and investment lead to an increase in total employment
and output due to the decline in real wage caused by the wealth ef-
fect and movements in labour supply. On the other hand, government
employment shocks crowd out private resources incurring by that a
negative wealth effect, raising the labour supply and shifting it to the
public sector which lifts real wages.
Using the New-Keynesian Sticky Prices model, government expendi-

ture shocks increase real wages because of the increased demand. Fol-
lowing a public investment shock, the demand effect dominates the
wealth effect and thus increases real wages, employment and out put.
Government employment shocks have similar effects in both models.
Burdett (2012) considers a model where the public sector is repre-

sented as a large firm with many outlets and the private sector could
be seen as many small firms each with a single outlet. A free entry
condition implies that at equilibrium the benefit of posting a vacancy
is equal to zero. The author adopts a constant return to scale Cobb-
Douglas matching function. Three public wage regions are considered,
the high public wage region, the medium public wage region and the
low public wage region.
5
Results show that an increase in public sector vacancies in the high or
medium regions crowds out private sector vacancies on a one-to-one
basis. The study also shows that, in the low public wage region, an
increase in the public sector wage increases the equilibrium level of un-
employment. An increase in public sector wages of the medium public
wage region implies a decrease in the average wage paid to employ-
ees in the private sector. The average private wage paid to employed
workers in the private sector is independent of an increase in wages
in the high public wage region. These results show that the average
private sector wage is non-monotonically related to the public sector
wage.
Michaillat (2014) introduces a search and matching model to a New

Keynesian model. In this framework, public policy varies across the
business cycle. The author relies on a government-consumption mul-
tiplier called the public-employment multiplier. Public and private
sectors hire from the same pool of employees, thus, the crowding out
effect is present. Results show that following a negative technology
shock, unemployment rises because the real wage is rigid. The author
also shows that the amplitude of the crowding out effect is governed
by the level of market tightness. The crowding out effect fades out as
the labour market becomes less tight.
Afonso and Gomes (2014) build a search and matching model that
permits for a bidirectional relation between private and public wage.
In this context, productivity shocks first affect the private sector wage
then propagate to the public sector wage through direct and indirect
mechanisms;
(a) Directly, through a direct relationship between private and public
wage.
(b) Indirectly, through an error correction mechanism. The model
also allows the private sector wage to be influenced by an exter-
nal power such as fiscal tightening which is transmitted to the
private sector through the public sector. The paper deals with
endogenous variables problem by estimating each equation sepa-
rately and instrumenting all the endogenous variables.
In their model, the error correction mechanism represents fric-

tions in the labour market. Without these frictions, the equilib-
rium wage ratio would always prevail.
Estimation results show that the two mechanisms are positive and sta-
tistically significant. A one per cent increase in the real public sector
6
wage growth increases private sector real wage growth by 0.3 per cent.
This represents the direct effect. A one per cent increase in public
sector employment increases the private wage by 0.2 per cent. Results
also show that the private sector wage is pro-cyclical.
Gomes (2014) studies the optimal public sector employment and wage
policy in the steady state and over the business cycle. This is done
by adopting a search and matching model in a two-sector dynamic
stochastic general equilibrium model. The author shows that in the
steady state, the optimal public sector wage policy should mirror the
differences in the probabilities of finding a job. Not following an opti-
mal policy would lead to higher equilibrium unemployment.
The author also shows that in order to avoid unemployed queues dur-
ing recessions and recruitment problems during periods of expansion,
public sector wage should follow the private sector wage.
1.2 Research Paper Framework and Results

Following Diamond (1982), Mortensen (1982), Petrongolo and Pissarides
(1990), I build a two-sector, private and public, search and matching model
that uses a constant return to scale Cobb-Douglas matching function. Pri-
vate sector wages are determined via an asymmetric Nash Bargaining pro-
cess, in which, employees and firms bargain about how to share the match
surplus or the value that will be lost if the two parties break the match. In
the model, there is a continuum of homogeneous workers with measure nor-
malized to 1. As in Merz (1995), I consider an infinitely-lived household that
regroups all members in the economy in such a way the income of household
members is pooled in a fashion that given the presence of unemployment
risk, consumption is equal among them.
The job destruction rate is different between sectors and is determined

exogenously. Unemployed members of the household are allowed to search in
only one of the two sectors, this assumption is known as the directed search.
Each member, whether she is employed or unemployed provides value to the
household. Nonetheless, the value of being unemployed cannot surpass the
value of being employed in any of the two sectors. The directed search as-
sumption results in an optimality condition; the value of being unemployed
and searching in any of the two sectors should be equal
7
The objective of the household is to maximize the expected lifetime util-
ity by choosing optimal levels of consumption and bond holdings. Firms
choose the number of vacancies they want to post as well as the number
of employees they want to hire in such a way to maximize the present dis-
counted value of profits. Both public and private sectors produce consump-
tion goods following a constant return to scale production technology, with
labour as the only input. Posting vacancies is costly, this cost is represented
in the production function where part of the produced goods goes to finance
it. These costs differ between sectors.
Unlike the private sector wage, which is determined via the Nash Bar-
gaining process, public sector wage follows the evolution of the private sector
wage. An error correction mechanism corrects, the differences between the
private sector wage and the public sector wage in such a way to maintain
the public sector wage premium.
In the model, technology, public vacancies and public wages are subject
to deterministic shocks. Previous literature has shown that these shocks
affect the private sector wage and thus private sector employment. The
mechanism in which this happens is the following: shocks to public sector
vacancies and wages crowd out private employment by increasing the num-
ber of unemployed searching for public sector jobs. Due to the diminishing
marginal productivity of labour, this crowding out effect increases marginal
productivity-raising by that private sector wages. The second mechanism
in which a deterministic shock on public sector vacancies or wages affects
private sector wages is the following: an increase in public sector wages or
public sector vacancies increases the value of being employed in the public
sector and thus the value of being unemployed and searching for a public
sector job. Since the latter is present in the bargaining solution, pressure
on private sector firms to increase wages emerges.
The increase in private wages results in a decrease in private employ-

ment and may cause an increase in unemployment if the public sector fails
to absorb the increasing number of unemployed searching for a public sector
job.
In the simulation performed on Matlab, I start by varying the steady

state level of distortionary taxes, public sector wage premium, public sector
matching efficiency and bargaining power. This draws a policy that exam-
ines the effects of each parameter on the steady-state levels of variables.
Then I proceed by performing impulse response analysis in a determinis-
tic framework. In this context, I first study the response of variables to
a permanent deterministic shock on technology, public wages and public
vacancies. Shocks on these variables replicate the sluggish economic perfor-
8
mance in Lebanon, that has been marked by years of stagnation. They also
try to replicate the increase in public sector wages and vacancies as in the
aftermath of the 2017 salary scale. Then I study the effect of both positive
and negative temporary TFP shocks on the economy.
Results show that an increase in the steady-state distortionary tax level

has the greatest impact on private sector employment. The latter dramati-
cally decreases following an increase in tax levels. Public sector employment
increases but is unable to absorb the mass of unemployed searching for a
public sector job. Thus, unemployment increases and total consumption
decreases. The decrease in private employment is caused by the increase
in private wages ignited by the crowding out effect and the reduction in
the value of the match surplus. On the other hand, an increase in steady-
state public sector matching efficiency, and despite the crowding out effect
it causes, decreases the unemployment level due to the ability of the public
sector to absorb a greater number of unemployed. Changing steady-state
levels of other parameters such as wage premium and bargaining power re-
sults in a decrease in private employment accompanied by a slight increase
in unemployment and thus total consumption.
Results also show that when combined with a public sector employment
stimulus plan, negative TFP shocks have a magnifying effect. Following
a negative TFP shock, if the government deploys an employment stimulus
plan to revive its economy, unemployment would raise even more dramati-
cally due to the magnified crowding out effect. The latter is caused by the
stimulus plan and the fact that a negative TFP shock increases unemploy-
ment. In the presence of an employment stimulus plan, a negative TFP
shock magnifies the crowding out effect. Moreover, employment stimulus
programs are ineffective even when the economy is hit by a positive TFP
shock. Despite the fact that unemployment is lower than in the case of neg-
ative TFP shock, the positive TFP shock is incapable of totally absorbing
the crowding out of the labour market.
Additionally, the model shows that following a permanent deterministic

technology shock, the economy is capable of absorbing the crowding out
caused by an employment stimulus pan. However, not adopting a stimulus
plan when there is a permanent deterministic technology shock results in
lower unemployment levels. A stimulus plan that is not followed by a per-
manent increase in technology levels would have a severe impact on unem-
ployment, especially that the crowding out is not absorbed by a technology
change. Finally, results show that most of the crowding out effect is caused
by the public wage increase and not public vacancies increase.
9
2 Lebanon’s Economic Environment
2.1 Lebanon’s Financial Situation
Lebanon is one of the highly indebted countries in the world. Due to cumu-
lative fiscal deficits over the past 10 years, the country’s debt soared around
75 U.S. billion dollars, generating by that a debt to GDP ratio of 145%.
The accumulated debt is primarily used to cover the interest accumulation,
which makes the problem even worse. Since the start of the Syrian civil war
in 2011, the government’s revenues grew at 1% yearly while its expenditures
kept growing at 5%. The International Monetary Fund estimates that, fol-
lowing the same trajectory, the fiscal deficit might reach 15% of the GDP
and the debt to GDP ratio could hit 200% by the year 2030.
According to the World Bank, the Lebanese GDP was around 52 U.S.
billion dollars in 2016 while the Lebanese population was around 6 million.
The GDP per capita in 2017 was equal to 8.800 U.S. dollars. The government
expenditures represent around 27% of the GDP. This number could reach
40% in the near future due to the new salary scale law which was agreed
upon in September 2017 as well as the new reforms and development pro-
grams. Debt servicing represents 36% of governmental expenditures. While
the public sector wage bill represents 33% of governmental expenditures.
Official studies estimate that the new salary scale would cost the Lebanese
government 800 U.S. million dollars yearly. While other economic estimates
suggest that the yearly real cost of the salary scale would be 1.8 U.S. billion
dollars.
2.2 Lebanese Labour Market Facts

Aside from the salary scale, public sector personnel costs (salaries, wages
and benefits) have been steadily increasing at 7.5% per year during the
last 10 years. Public sector employees’ salaries correspond to 46% of total
government revenues, while it is around 28% for peer countries. Based on
the Investment Development Authority of Lebanon and Yaacoub and Badre
(2011), in 2007, 11.7% of all employees were employed in the public sector
while the other 88.3% were employed in the private sector, the population
was estimated to be around 4,223.553 of whom 2.831 million were above
the age of 15. The active population was 1.229 million, while the inactive
population was 1.602 million. These figures correspond to a participation
rate equal to 43.4 %.
According to Jaoude (2015) the labour force participation rate and em-
ployment rates were 49.2% and 43.6% respectively. While the World Bank
estimates that the participation rate was around 47% for 2018.
10
On the other hand, there is no reliable estimation for the unemployment
rate. The World Bank report of 2012 sets the national unemployment rate
at 11%; the Central Administration of Statistics(CAS) sets the unemploy-
ment rate at 6%; the Ministry of Labour estimates it to be between 20 and
25% for the same period.
In their 2012 report Robalino and Sayed (2012), the World Bank esti-
mates that the public administration employs 30% of wage employees, the
majority of them with higher education. Between 1997 and 2009, the gross
domestic product expanded at an average rate of 3.7 per cent per year, yet
employment grew by only 1.1 per cent thus, the employment-growth elas-
ticity is as low as 0.2.
Limited to no data concern the dynamics of jobs creation and destruc-

tion. Self-employment makes up 36% of the labour force. Public sector
vacancies are appealing since wage in the public sector are slightly higher
than to those of the private sector, while benefits from public sector jobs
exceed those of the private sector.
In their brief policy in 2015, the International Labour Organization es-

timates that the public sector employs 110.000 workers. Always according
to the ILO, around 2.800 job vacancies of all types were listed for Beirut,
Mount Lebanon and the North Governorate for the period December 2014
to February 2015. Out of these 2.800 job openings, 850 were in the public
sector.
According to the United Nation Development Program (UNDP), the es-

timated number of yearly jobs creation does not exceed 5.000, while the
number of new entrants to the labour market reached 32.000 in 2013. While
for Gohlke-Rouhayem, Melki, and Weinmann (2016) The yearly entrants to
the labour market were 23.000, and the job creation rates were 12.000 to
15.000 new jobs per year over the last 10 years.
In 2018 and following the new salary scale, the Lebanese government in-
tended to post 5.000 vacancies in the public sector and open 3.000 vacancies
in security bodies.
The most powerful trade union in Lebanon accounts only for 2.5% of
the total labour force. This weak representation is mirrored by the weak
bargaining power of the union trades.
11
3 The model
I use a search and matching model with two sectors, private and public. Fol-
lowing Petrongolo and Pissarides (2001), the search and matching framework
introduces frictions that hinder the unemployed from finding jobs. This ap-
proach is governed by a Constant Return to Scale Cobb-Douglas matching
function. The search and matching model is suitable since, without these
frictions, the public and private wages would equate due to arbitrage.
I also rely on the assumption of directed search, i.e. each unemployed
searches in only one of the private or public sector. This assumption is
preferred over the random search one due to the increasing number of micro-
founded evidence that supports it. Notably, the paper of Blank (1985)2 and
Heitmueller (2006)3 .
The private sector wage is determined via Nash Bargaining with unequal
bargaining powers. Following the data for similar Middle Eastern countries,
a public sector wage premium is present. The public sector wage follows the
one of the private sector, with the help of an error correction mechanism
that tries to sustain the public sector wage premium.
The agent in this economy is modelled via an infinitely lived household

that contains a big number of individuals with different consumption habits
due to the presence of unemployment risks and different risk preferences.
The presence of the household equalizes consumption among all individuals.
At each period the household chooses the level of consumption and bond
levels in order to maximize his utility. The household takes the level of pub-
lic goods as given.
Each individual or member of the household provides value to the house-

hold. This value depends on the sector in which the agent is employed, or
whether she is unemployed and searching for a job in one of the two sec-
tors. In my model, there is no idiosyncratic preference for public sector
jobs. Thus, the optimality condition would imply that the value of being
unemployed and searching for a job in the private sector should be equal to
the value of being unemployed and searching in the public sector. Without
this condition, we would have unemployment queues in one sector and em-
ployment problems in the other sector
2
The author relies on a reduced form two-way probit model that determines in which
sector an unemployed is more likely to search. He shows that: the sectoral choice is
influenced by wage comparison. This enables the public sector to control the number of
unemployed searching for a job in this sector by altering the public sector wage
3
The author gives evidence on the directed search and shows that wage differential
between sectors is an important driving force for sectoral assignment
12
Posting a vacancy in the private or public sector incurs costs. These
costs differ between the two sectors.
Private and public employment evolves according to a law of motion that

includes a job destruction rate. The latter differs between sectors.
Firms exhibit a labour based production function, they chose the num-
bers of vacancies to post as well as the number of employees to hire in such
a way to maximize profits subject to the law of motion of employment in
the private sector.
The government also produces goods via a labour based production func-
tion. Distortionary taxes are set exogenously as have been the case in
Lebanon where these taxes have not changed since more than a decade.Public
sector vacancies are equal to their steady state level plus a shock.
Three types of shocks are taken into account: public sector wages shock,
public sector vacancies shock and technology shock.
3.1 General Setting

The number of employees is scaled in such a way that the total labour force
equals one. Individuals fall into one of the three categories: unemployed,
employed in the private sector, employed in the public sector. There is no
heterogeneity between workers, i.e. they all present the same level of educa-
tion and abilities. The economy has two sectors, the private and the public
one, they are represented by the superscripts i = p, g while the subscript t
indicates time.
The labour force is modelled by the following equation:
1 = ltp + ltg + u. (1)
ltp , ltg and ut stand respectively for the proportion of workers employed in
the private, public sector and unemployed.
The law of motion of employment in each of the two sectors sectors is :

i
lt+1 = (1 − λi )lti + mit , i = p, g (2)
It describes the evolution of employment. The share of employed in period

t + 1 and sector i depends on the share of employed in period t and sector i,
lti , the job destruction rate in sector i, λi as well as the number of successful
matches in sector i and period t, mit which is obtained from a Cobb-Douglas
13
matching function described below.
I adopt a constant return to scale Cobb-Douglas matching function since

it captures the frictions in the labour market without adding much of com-
plexity to the model all while satisfying the properties of a well behaved
matching function. m(0, v) = m(u, 0) = 0, increasing and concave in both of
its arguments4 . I also adopt a CRS Cobb-Douglas matching function due to
the many evidences showing that this type of functions successfully replicates
real-world data. In numerical calculations the aggregate matching function
is indistinguishable from a CRS Cobb-Douglas. Evidence for the constant
return to scale Cobb-Douglas matching functions include Petrongolo and
Pissarides (2001), Blanchard, Diamond, Hall, and Murphy (1990) and Burda
and Wyplosz (1994).
The aim of the matching function is to pair unemployed workers with

vacant jobs. It can be written as :
i i
mit = m̄i uit η vti 1−η , i = p, g (3)
In the above matching function, mit stands for the number of new matches
in sector i and time t, m̄i stands for the matching efficiency in sector i, uit
represents the number of unemployed searching for a job in sector i = p, g,
η i represents the elasticity of the match, vti represents the vacancy rate in
sector i at time t.
The probability of filling a vacancy in sector i and time t is denoted as

qti , the conditional job finding rate in sector i and time t is denoted as pit
and the unconditional job finding rate in sector i and time t is denoted as
fti . These probabilities are presented respectively below.
mit i mit i mit

qti = , p = ,f = , i = p, g (4)
vti t uit t ut
3.2 Households
The household can consume two types of goods. Private sector goods ct and
public sector goods gt . The quantities consumed by the latter are taken as
constant, i.e. the consumer does not have the power to alter the consump-
tion of public goods.
The members of the household receive an income that equalizes consump-

tion among them. This assumption is important since with the presence of
4
Concavity implies that for h1 = (u1 , v1 ), h2 = (u2 , v2 ) and a scalar λ in [0, 1], f (λh1 +
(1 − λ)h2 ) ≥ λf (h1 ) + (1 − λ)f (h2 ).
14
unemployment risks and different levels of risk aversion, consumption would
not be equal among all members if they receive the same income.
The objective function is the following:

+∞
X
max∞ E0 β t [ln(ct ) + ζln(gt )] (5)
{ct ,Bt }t=0
t=0
it represents the expected lifetime utility for an infinitely-lived household

where ct stands for private goods consumption at time t, Bt stands for
bonds holding at time t, β stands for the discount factor, β ∈ (0, 1) and gt
stands for the public good consumption at time t.
I use a logarithmic utility function 5 that belongs to the isoelastic utility

1−σ
functions family u(c) = c 1−σ−1 this means that it exhibits a constant rel-
00
ative risk aversion, the relative risk aversion is R(c) = −c uu0 (c)
(c)
, R(c) = σ,
as a specific example of constant relative risk aversion, the utility function
u(ct ) = ln(c) implies a relative risk aversion equal to 1. therefore, decisions-
making is unaffected by scale, the relative risk aversion measure is invariant
with the level of consumption.
Using the logarithmic utility function implies that the elasticity of in-
tertemporal substitution εu(c) = 1/σ = 11 = 1 6 . Thus the income effect and
substitution effect offset. The logarithmic utility function also satisfies some
desirable properties7 .
The household maximizes his utility subject to a budget constraint. This

5 c1−σ − 1
Using l’Hôpital’s rule, the limit of u(c) is log c as σ goes to 1: lim = ln(c)
σ→1 1−σ
ct1−σ −1
6
Since u(ct ) = 1−σ belongs to CRRA utility functions family we have u (ct ) = c−σ 0
t
0
u (ct+1 ) ct+1 ∂ ln(ct+1 /ct ) 1
therefore ln = −σ ln and − = = σ.
u0 (ct ) ct ∂ ln(u0 (ct+1 )/u0 (ct ))
7
∂2f

(a) the function is concave on C, i.e. the Hessian matrix Hi,j = is
∂ci ∂cj
negative-semidefinite. Implying positive but decreasing marginal utility for
consumption ci ∂f (c)/∂ci > 0 ∂ 2 f (c)/∂c2i < 0
(b) the limit of the first derivative is positive infinity as ci approaches 0:
lim ∂f (c)/∂ci = +∞
ci →0
(c) the limit of the first derivative is zero as ci approaches positive infinity:
lim ∂f (c)/∂ci = 0
ci →+∞
15
one is presented in the following equation.
ct + Bt = (1 + rt−1 )Bt−1 + (1 − τt )wtp ltp + (1 − τt )wtg ltg + zt ut + Πt (6)
As before, ct and Bt stand respectively for the consumption and bonds

holding at time t, rt−1 stands for the interest rate from timet−1 to t, τ stands
for the distortionary income tax rate. Thus (1 − τt )wtp ltp and (1 − τt )wtg ltg
stand respectively for the net wage for those working in the private and pub-
lic sector. zt stands for the unemployment benefit per unemployed person.
Thus zt ut represents the amount of unemployment benefits received by the
household at period t. Finally, Πt stands for the lump sum transfers from
and into firms.
The Lagrangian equation for the household problem is:
+∞
X
Lt = E0 β t [ln(ct ) + ζln(gt ) − λt (ct + Bt − (1 + rt−1 )Bt−1
{ct ,Bt }∞
t=0 t=0
−(1 − τt )wtp ltp − (1 − τt )wtp ltp − zt ut − Πt )](7)
From the first order conditions 8 we obtain the Euler equation

ct
β(1 + rt )Et [ ] = 1(8)
ct+1
It represents the solution to the above constrained maximization prob-

lem. i.e. maximizing the lifetime expected utility (equation 5) subject to
the budget constraint (equation 6). Notice that the Euler equation can be
ct ct
written as : (1 + rt )βEt [ ct+1 ] = 1 while βt,t+1 = βEt [ ct+1 ] stands for the
stochastic discount factor or the marginal rate of substitution i.e. the rate
at which the consumer is willing to substitute period t + 1 consumption with
period t consumption.
3.3 Workers
The value to the household of each employed member differs based on
whether she works in the private or the public sector. It increases as the
job destruction rate decreases. The value to the household of an employed
member in sector i and period t is denoted as Wti and can be represented
as:
Wti = (1 − τt )wti + Et βt,t+1 [(1 − λi )Wt+1
i
+ λi Ut+1
i
], i = p, g. (9)
8 ∂Lt ∂Lt
∂ct
= 0 gives ∂ct
= β t ( c1t − λt ) = 0 which gives 1
ct
= λt
∂Lt ∂Lt
∂Bt
= 0 gives ∂Bt
= β t (−λt ) + β t+1 Et λt+1 (1 + rt ) = 0 substituting λt by 1
ct
and λt+1
1 ct
by ct+1 gives us the Euler equation β(1 + rt )Et [ ct+1 ]=1
16
As mentioned previously, (1−τt )wti stands for the net wage for a member
employed in sector i at time t. It is important to state that the value of an
employed member does not depend solely on the current net wage, but also
on the continuation value of being employed in sector i, (1−λi )Wt+1
i +λi U i
t+1
i i
where λ stands for the job destruction rate in sector i and Ut+1 stands for
the value to the household of an unemployed member searching for a job in
sector i at period t + 1. βt,t+1 stands for the stochastic discounting factor,
it is calculated as:
ct
βt,t+1 = βEt [ ] (10)
ct+1
Unemployed members also provide value to the household. This value
differs whether the unemployed is searching for a job in the private or public
sector. The value to the household of an unemployed member searching for
a job in sector i at time t is denoted as Uti .
Uti = zt + Et βt,t+1 [pit Wt+1

i
+ (1 − pit )Ut+1
i
], i = p, g (11)
Remember that we have made the assumption that the unemployed can
search for a job in only one of the two sectors, private and governmental.
This assumption is known as the directed search assumption. Thus, the
value to the household of an unemployed member depends on whether this
member is searching for a job in the private or governmental sector.
Where zt stands for the unemployment benefits plus the value of home
production and pit stands for the conditional job finding rate in sector i.
Using the directed search assumption, unemployed members can search

for a job in only one of the two sectors. Thus, optimality condition states
that the value of an unemployed member searching for a job in the private
sector should be equal to the one of searching in the private sector. Without
this optimality condition, unemployed queues would form for jobs in the
sector offering higher unemployment value Uti , while the other sector would
face recruitment problems. The optimality condition can be represented as
follows:
Utp = Utg = Ut (12)

Without labour movements between the private and public sector, there
is no adjustment in the value of being unemployed. Thus, the optimality
condition implies that dynamics between sectors exist in such a way Utp and
Utg equalize.
The optimality condition can also be written as :
mpt Et [Wt+1
p
− Ut+1 ] mg Et [Wt+1
g
− Ut+1 ]
= t (13)
(1 − st ) st
17
Writing the optimality condition in this fashion enables us to determine
the share of unemployed searching for a job in the governmental sector st .
It is worth mentioning that the share of unemployed searching for a public
sector job st depends on the value of being employed in the public sector,
as well as the number of vacancies posted in each sector.
3.4 Firms
Private firms produce goods using labour as a production factor. Costs of
posting vacancies represent the production costs. Thus, part of the goods
produced go to finance these costs. The private consumption good is denoted
by yt . Its production function is the following:
p(1−α)
yt = at (lt − θp vtp ) (14)
In the above production function, at stands for technology at time t, α

stands for the capital share of the production function, θp stands for the
cost of posting a vacancy in the private sector and vtp stands for the number
of vacancies posted in the private sector at time t.
Technology at follows an autoregressive process of order 1 with a drift.
at = ρat−1 + (1 − ρ)ā + at (15)
This equation represents the law of motion of technology, where, ρ stands

for the persistence coefficient, ā stands for the steady state value of technol-
ogy and at is whether a permanent deterministic shock that, when applied,
shifts the steady state level of technology to new levels or a deterministic
temporary TFP shock that hits the economy in the first period then prop-
agates affecting by that the variables.
The objective of the firm is to maximize its present discounted value of

profits. In order to do so, it selects the number of vacancies it wants to post
in period t, vt as well as the number of workers it wants to hire in period
t + k. The objective function which is the present discounted value of profits
is the following:
+∞
p(1−α) p p p
X
max
p
Et βt,t+k [at+k (lt+k − θp vt+k ) − wt+k lt+k ](16)
{vt ,lt+k }∞
t=0 k=0
The firm maximizes the above equation, taking into account as a con-
straint the law of motion of employment in the private sector that is pre-
sented below:
p
lt+1 = (1 − λp )ltp + qtp vtp (17)
18
The Lagrangian for this constrained maximization problem becomes:
+∞
p(1−α) p p p
X
Lt = Et βt,t+k [at+k (lt+k − θp vt+k ) − wt+k lt+k +
p
{lt+k ,vt }∞
t=0 k=0
µt ((1 − λp )ltp + qtp vtp − lt+1
p
)](18)
for k = 0 we have:
+∞
p(1−α)
− θp vtp ) − wtp ltp +
X
Lt = E0 βt [at (lt
p
{lt+1 ,vt }∞
t=0 k=0
µt ((1 − λp )ltp + qtp vtp − ltp )](19)
From the first order conditions9 we obtain:

p
θp at+1 p−α wt+1 θp
p = Et βt,t+1 [(1 − α)lt+1 − + (1 − λp ) p ] (20)
qt at at+1 qt+1
This represents the solution to the firm problem, i.e. the maximization of
the present discounted value of profits subject to the law of motion of private
sector employment. The above equation carries an important concept; the
expected cost of hiring a worker, the left-hand term of the equation equals
the discounted expected profit of hiring a worker, the right-hand term of the
equation. The latter includes the marginal productivity of new workers (1 −
p
p−α wt+1
α)lt+1 , wages relative to technology in period t+1 at+1 and the continuation
p
value of the match (1 − λp ) qθp .
It is important to mention that, due to the
t+1
decreasing marginal productivity of labour, the crowding out effect decreases
the number of unemployed searching for private sector job, thus increases
the marginal productivity of the newly hired workers.
3.5 Nash Bargaining and Private Sector Wage Determina-

tion
The private sector wage is determined via an asymmetric Nash Bargaining
process. The asymmetry is captured via different bargaining powers between
workers and firms. The following describes the Nash Bargaining process.
wtp = argmax
p
(Wtp − Ut )b (Jt )1−b
wt
9 ∂Lt ∂Lt p−α p

p
∂lt+1
= 0 gives p
∂lt+1
= −µt + Et βt,t+1 [(1 − α)at+1 lt+1 − wt+1 + µt+1 (1 − λp )] = 0
p−α p
which gives µt = Et βt,t+1 [(1 − α)at+1 lt+1 − wt+1 + µt+1 (1 − λp )].
at θ p
∂Lt
p
∂vt
= 0 gives ∂Lt
p
∂vt
= −at θp + µt qtp = 0 which gives at θp = µt qtp and µt = qt
p .
19
In the above equation, wtp stands for the private sector wage at period
t, Wtp and Ut follow the same definition as in previous sections, b stands for
workers’ bargaining power and Jt stands for the value of a marginal job for
the firm. It is defined in the equation below:
Jt = at (1 − α)ltp−α − wtp + Et βt,t+1 [(1 − λp )Jt+1 ] (22)
.
at (1 − α)ltp−α is obtained from the derivative of private sector consump-
tion goods production function with respect to private sector employment.
The solution to the bargaining problem is the following:
b(1 − τt )
(Wtp − Ut ) = (Wtp − Ut + Jt ) (23)
1 − bτt
The solution carries an important concept which can be represented in
the fact that an increase in distortionary tax levels τt lowers the share of the
surplus going to the workers. Without such a tax, the share of the surplus
received by the workers would equal their bargaining power b. Therefore,
following a distortionary tax raise, workers might accept lower wages in
order to avoid higher taxes going to a third party; the government.
3.6 Government
As in the private sector, the government produces public goods using labour
as the production factor. Moreover, part of the produced public goods go to
finance the production costs represented by the cost of posting vacancies in
the public sector. The production function of the public consumption good
is the following:
gt = at (ltg − θg vtg ) (24)

In the above equation θg stands for the cost of posting a vacancy in
the public sector while vtg stands for the number of vacancies posted in the
public sector.
The unemployment benefit follows the progress of technology. This is

described by the following equation:
zt = zat (25)
Notice that z is different from zt . The former is a parameter and stands

for the replacement ratio of the salary, it includes unemployment benefits,
home production value and the value of leisure. The latter is a variable and
is determined as in equation 25.
20
The government sets its wages one period before setting vacancies. The
growth of public sector wages depends on the expected growth of private sec-
tor wages plus an error correction mechanism that re-establishes the public
sector wage premium in such a way it matches the target premium. Public
sector wages are subject to a permanent deterministic shock wt that takes
the public sector wage to a new steady-state level. The following equation
explains how wages in the public sector evolve.
g p g
wt+1 wt+1 wt−1
= E t [ ] + κ[ − 1 − Ψ] + w (26)
wtg wtp p
wt−1 t
Public sector vacancies are set to their steady state levels. As public
sector wages, they are subject to a permanent deterministic shock vt that
takes the number of vacancies to a new steady-state level. The following
equation depicts the evolution of public sector vacancies.
vtg = v̄ g + vt (27)
In the above equation vtg stands for public sector vacancies, and v̄ g stands
for steady state public sector vacancies level. It is worthy to mention that
in the model, the distortionary income tax is considered as an exogenous
parameter since the Lebanese government has not changed it since a decade
and because is not a major component of the government’s revenues.
3.7 Equilibrium
Taking public sector vacancies, wages and taxes {vtg , wt+1
g
, τt }∞
t=0 as given,
the competitive equilibrium is characterized as follows: (i) the household
chooses the sequence of consumption {ct }∞ t=0 that maximizes his lifetime
utility (equations 5 through 8), (ii) the household chooses the fraction of
unemployed searching for a job in the public sector s in such a way the
optimality condition holds and the value of being unemployed and search-
ing in one of the two sectors equates (equations 12 and 13), (iii) private
sector firms maximize their profits subject to the law of motion of private
employment (equations 16 through 20), iv) private sector wages wtp solve
the Nash bargaining condition (equations 21 through 23) and (v) the goods
market clears ct = yt + gt . The equilibrium results in a sequence of prices
{vtg , wt+1
g
}∞
t=0 that satisfy the above conditions.
21
4 Calibration
The steady-state level of unemployment, private sector employment as well
as public sector employment are set to match the data respectively at, 15%,
76.5%, and 8.5% of the total labour force. Using these figures, and as seen
in the data, public sector employment represents 10% of total employment.
The public sector labour market tightness is set at 0.0704. This figure
relies on the numbers of Jaoude (2012) for the year 2012; declared vacancies
in the public sector were 2164 while the unemployed searching for a job in
the public sector were 30756. The income tax rate is set at 2%, the cur-
rent income tax prevailing in Lebanon. Following the previous literature,
the capital share of production is set at 0.3, while the bargaining power is
set at 0.35. Very rare to no data is present on the bargaining power of the
employees in Lebanon, however, based on the fact that the most powerful
trade union in Lebanon accounts only for 2.5% of the labour force, I set the
steady state bargaining power at 0.35 while Afonso and Gomes (2014) set
it at 0.43 for the United Kingdom.
The model is calibrated at a quarterly frequency, the stochastic discount

factor is set at 0.985 in a fashion to match the yearly interest rate prevail-
ing in Lebanon which is around 4%. The persistence of technology ρ is set
at 0.95 as in Hansen (1985) and Ireland (2001). Following Petrongolo and
Pissarides(2001), the elasticity of the match with respect to unemployment
in the public and private sector, η g and η p is set at 0.5. The job destruc-
tion rate in the public and private sectors: λg and λp are set at 0.005 and
0.01 respectively. Once again, there is no data regarding the job destruction
rates in the Lebanese labour market, thus I take the numbers of Afonso
and Gomes (2014) and divide them by half, given that the Lebanese labour
market is not as dynamic as the British one. Also as Afonso and Gomes
(2014), I set the error correction mechanism coefficient κ at -0.05.
I set the steady-state fraction of unemployed searching for a public sec-

tor job s at 0.3. This figure is obtained by dividing 31.000 (the number of
unemployed searching for a public sector) obtained from Jaoude (2015) by
110.000 (the number of unemployed) this gives s = 0.28.
The fraction of public sector vacancies is set at 0.28. This is obtained

from the report of the International Labour Organization, where around
2.800 job vacancies of all types were listed for Beirut, Mount Lebanon and
the North Governorate for the period December 2014 to February 2015. Out
of these 2.800 job openings, 850 were in the public sector. This coincides
with a fraction of public sector vacancies equals to 0.303. I reduce this one
to 0.28 since the ILO report considers vacancies posted for the Capital and
22
the North, where the presence of the public sector is more pronounced than
in the rest of the country.
In the deterministic simulation, I set the end-value of the public sector

permanent deterministic wages shock w t in such a way that the public sec-
tor wage grows by 4.25% in 100 quarters starting from the beginning of the
exercise. The public sector permanent deterministic vacancies shock vt is
set in a fashion that the public sector vacancies increase by 28%. Finally,
the permanent deterministic technology shock at is set in a fashion that
mimics the sluggish economic performance in Lebanon growing by 10% in
100 quarters starting from the beginning of the exercise. On the other hand,
the deterministic but temporary technology shock, i.e. the technology shock
that hits the economy only in the first quarter or the positive TFP shock is
set in a fashion that technology increases by 10% in the quarter following
the shock then slowly comes back to its initial steady-state level. A similar
calibration is used in the negative temporary technology shock or negative
TFP shock.
I variate the steady-state levels of distortionary taxes, public sector wage

premium, bargaining power and public sector matching efficiency since they
all represent important policy parameters. Moreover, the variation in the
tax level is relevant since, in Lebanon, the income tax has been stable for
several years around 2%. Thus, it would be interesting to study the impact
of an income tax change on the economy. On the other hand, I change the
steady-state level of the bargaining power since the union labour is very
weak in Lebanon, thus, it would be interesting to see what happens if a
more organized union labour bargains for the matching surplus. Finally,
I vary the steady state level of public sector matching efficiency since the
latter is very low and could be due to the sectarian recruitment program.
Thus, varying the matching efficiency could mimic a potential change of the
sectarian recruitment program.
23
5 Results
Employment and Unemployment Employment and Unemployment
Steady State Tax Level Steady State Public Sector Wage Premium Level
Employment and Unemployment Employment and Unemployment
Steady State Bargaining Power Level Steady State Public Sector Matching Efficiency Level
Figure 1: The Reaction of the Labour Force to a Change in the Steady

State Level of: Distortionary Tax, Public Sector Wage Premium, Bargaining
Power and Public sector Matching Efficiency
The left graph of the top panel shows that an increase in the steady-state
distortionary tax level would result in a sharp decrease in private sector em-
ployment as well as an increase in unemployment and public employment.
This increase in tax has two opposite effects. The first being the reduction of
the share of surplus going to the workers captured by the Nash Bargaining
solution: (Wtp − Ut ) = b(1−τ t) p
1−bτt (Wt − Ut + Jt ). This leads workers to save on
their tax bill by accepting lower wages. The second effect is the reduction
of the match surplus; (Wtp − Ut + Jt ), that obliges private employers to raise
wages in order to keep on recruiting new workers.
As taxes increase, the number of unemployed searching for a public sector

job increases, which crowds out the private labour market. This increase in
the number of unemployed searching for a public sector job is caused by the
decrease in private sector vacancies. This crowding out effect combined with
24
the decreasing marginal utility of labour, increases the marginal productiv-
ity of new employees, causing private sector wages to hike. This increase in
wages reduces private employment and increases by that unemployment.
The right graph of the top panel stands for the reaction of the labour
market to an increase in the steady-state public sector wage premium. It
exhibits the same patterns observed in the tax raise scenario. However, the
magnitude of change is much lower. In this case, the crowding out effect
does not occur due to a decrease in private sector vacancies, but due to a
disproportionate increase in the value of being employed in the public sector
caused by a disproportionate increase in the public sector wages.
The increase in the wage premium results in an increase in the value

of being employed in the public sector as well as the value of being un-
employed. Which puts pressure on the bargaining power. Unlike the tax
case where the value of being employed decrease, in this case, the increase
in private sector wages occurs via a different mechanism. That is; putting
more pressure on the bargaining power and thus increasing wages. This
is amplified by the increasing share of unemployed searching for a public
sector job. Additionally, the lower magnitudes observed in this case are
due to the lower crowding out effect. In the tax raise scenario, the share
of unemployed searching for a public sector job rapidly increases incurring
by that a greater increase in marginal productivity and thus private wages.
This rapid increase in s is justified by the severe decrease in private sector
vacancies. This is not the case when considering the public sector wage pre-
mium; private vacancies increase and absorb some of the crowding out effect.
The left graph of the lower panel studies the reaction of the labour force
to a change in the bargaining power. A slight decrease in both private and
public sector employment is observed with an increase in unemployment to
compensate for the decrease in employment. This can be explained by the
fact that higher bargaining power increases the share of the surplus going
to private sector employees which puts pressure on private firms, increas-
ing by that wages. However, the increase in wages is not as severe as in
the previous cases since, despite the bargaining power increase, the number
of unemployed members searching for a public sector job decreases. Thus,
in this case, the crowding out effect is not present. Since more unemployed
would want to work in the private sector, and given the diminishing marginal
return, the private sector wage decreases. These two opposite forces result
in a slight increase in the private sector wage and thus a slight decrease in
private employment.
The right graph of the lower panel shows the reaction of the labour
market to an increase in the public sector matching efficiency. Unlike the
25
previous cases, the increase in the matching efficiency slightly decreases un-
employment despite the large decrease in private employment. Once again,
the number of unemployed searching for a public sector job increases rapidly,
which creates a crowding out effect increasing by that private sector wages.
However, and unlike previous scenarios, the probability of filling a job in the
public sector increases sharply, absorbing by that the unemployment created
by the crowding effect and the increase of private sector wages.
Period Period
Figure 2: The Reaction of the Labour Market to a Permanent Technology

Shock, a Public Sector Job Vacancies Shock and a Public Sector Wage Shock
In the left graph above, we see the reaction of the labour market to
a permanent deterministic technology shock combined with a permanent
deterministic public sector vacancies and salaries shock. We notice that
subject to these shocks, private employment starts by decreasing then in-
creases slightly to stay below its initial level. On the other hand, public
sector employment increases steadily, and unemployment presents a hump
shape, starting by increasing then decreasing below its initial value.
The crowding out effect caused by the increase in the number of unem-
ployed searching for a public sector job due to the increase in public sector
wages and vacancies raises private sector wages and thus reduces private
employment. Also, the increase in the value of being employed in the public
sector increases the value of being unemployed and searching for a public
sector job. This puts pressure on the bargaining power increasing by that
private sector wages, the effect is amplified due to the fact that a greater
number of unemployed are searching for a public sector job.
However, and despite all these factors that play a role in increasing
private sector wages and thus decreasing private employment, the labour
market is capable of rebounding and coming back to its initial levels.
26
The right graph of the above panel shows the reaction of the labour
market to a deterministic permanent increase in public sector vacancies and
wages. In this graph, the decrease in private sector employment is more
speaking than in the previous case and is not followed by a rebound. This is
mainly due to the absence of the technology shock. The increase in public
sector employment is steady and slightly greater than in the previous case.
Interestingly, at the end of the exercise, unemployment is still above its ini-
tial level.
Despite the fact that wages grow at a slower pace when we do not con-
sider a permanent change in technology, the increase in wages combined
with the severe decrease in private sector vacancies caused by the perma-
nent increase of public wages and vacancies has a greater crowding out effect
in comparison to the case where technology increases permanently.
This is expressed by the number of unemployed searching for a public

sector job that increases and stays above the number of unemployed search-
ing for a private sector job, inducing by that a constant crowding out effect.
It is also worth mentioning that the sharp decrease in private sector vacan-
cies, increases the value of being employed in the public sector, which puts
pressure on the bargaining power and thus increases wages. Finally, since
total employment decreases, then the increase in wages caused by the in-
crease in the value of being employed in the public sector and the crowding
out effect is relatively stronger than the increase in wages caused by the shift
of the steady-state level of all three variables, especially that an increase in
steady-state level of technology raises wages naturally while also raising em-
ployment. A More sophisticated and complete approach is described below.
27
Negative TFP Shock : Employment Stimulus Plan Vs No Plan, Unemployment
Period
Figure 3: The Transition Path of Unemployment Subject to a Negative TFP

Shock, The Case Of Employment Stimulus Plan Versus No Plan.
In the above figure, and following a negative TFP shock, the level of
unemployment is higher in the case where the government decides to adopt
an employment stimulus plan i.e. when it increases public sector wages and
vacancies. This result is very interesting, it shows that following a nega-
tive TFP shock, employment stimulus plans are ineffective, they actually do
more harm than good by further increasing unemployment and decreasing
by that the aggregate consumption. A negative TFP shock increases un-
employment as in the standard literature and as seen in the figure above,
however, if the government decides to adopt an employment stimulus plan
by increasing public sector vacancies and wages it would magnify the ef-
fect due to the increase in the value of being employed in the public sector
and thus the share of unemployed searching for a public sector job, this
would put pressure on the bargaining power and thus raise private wages
also the increase in the share of unemployed searching for a public sector
job increases the marginal productivity of the match raising by that the
private wage. However, as unemployment increases due to the TFP shock,
and as the share of unemployed searching for a public sector job increases
the crowding out effect would be very speaking and would raise unemploy-
ment significantly as seen above (the unemployment rate is at 25% after 20
quarters in the employment stimulus plan scenario).
28
Transition of Unemployment Positive TFP VS Negative TFP shocks Transition of Unemployment: The Effect of a Negative TFP Shock
Period Period
Transition of Unemployment Subject to Different Shocks Transition of Unemployment Subject to Different Shocks
Period Period
Figure 4: The Transition Path of Unemployment Subject to: i) A De-

terministic positive TFP Shock Augmented by a Public Sector Vacancies
and Wages Shock (T F P, all), A Deterministic Negative TFP Shock Aug-
mented by a Public Sector Vacancies and Wages Shock (N egativeT F P, all),
ii) A Permanent Deterministic Shock on Public Sector Vacancies and Wages
(v g , wg ), A Deterministic Negative TFP Shock Augmented by a Public Sec-
tor Vacancies and Wages Shock (N egativeT F P, all), iii) A Permanent De-
terministic Technology Shock (a), A temporary deterministic TFP shock
(T F P, only), A Deterministic TFP Shock Augmented by a Public Sector
Vacancies and Wages Shock (T F P, all) iv) A Permanent Deterministic Tech-
nology Shock (a), A Permanent Deterministic Shock on Technology, Public
Sector Vacancies and Wages (All), A Permanent Deterministic Shock on
Public Sector Vacancies and Wages (v g , wg ), A Permanent Deterministic
Shock on Public Sector Wages (wg ) and A Permanent Deterministic Shock
on Public Sector Vacancies (v g )
29
The left graph of the upper panel shows the impact of deploying a public-
sector-based employment stimulus program when the economy is hit by a
positive TFP shock versus when the economy is hit by a negative TFP shock.
Results show that despite the positive TFP shock if the government deploys
a stimulus program by raising public wages and posting more vacancies the
unemployment level would increase. However, and as shown above, this in-
crease is not as severe as in the case where the TFP shock is negative since a
positive TFP reduces the number of unemployed and thus absorbs some of
the crowding out effect caused by the increase in public wages and vacancies.
The right graph of the upper panel confirms that in the presence of a
public employment stimulus plan, a negative TFP shock increases unemploy-
ment via the magnifying effect; negative TFP shocks increase unemployment
and stimulus programs increase the share of unemployed searching in the
public sector, thus, further worsening the problem due to a magnified crowd-
ing out effect. This is not the case when there is no negative TFP shock,
despite the normal crowding out effect, the magnified crowding out effect is
not present.
The left graph of the lower panel shows that the impact of a positive TFP
shock depends on whether the government deploys an employment stimulus
plan or not. A positive TFP shock when not combined with an employment
stimulus program temporarily reduces unemployment due to the increase
in public and private employment it creates. However, when this positive
shock is combined with an employment stimulus plan, the unemployment
level increases. This shows that the TFP shock is not able to absorb the
crowding out effect caused by the increase in public wages and vacancies. On
the other hand, a permanent deterministic shock on technology, when not
combined with a stimulus plan, takes unemployment to a lower steady-state
level, this is not the case for a temporary TFP shock where unemployment
rebounds. However, technological progress rarely happens in this form, it
usually takes the form of a temporary shock as a TFP shock.
The right graph of the lower panel shows that when a permanent increase
in the steady-state level of technology is combined with an employment stim-
ulus plan, unemployment presents a hump-shape increasing at first then de-
creases as it converges to a new steady-state with lower unemployment rate.
However, following a deterministic permanent shock on technology, unem-
ployment rate converges quickly to a lower steady-state level without any
increase in unemployment as in the case of a stimulus plan. In the graph,
we also see that, without a permanent increase in the steady-state level of
technology, adopting an employment stimulus plan would have catastrophic
effects raising unemployment dramatically to a new steady state around
21%. This is due to the crowding out effect caused by the stimulus plan
30
that is not offset by a positive permanent increase in technology that ab-
sorbs part of the crowding out effect by lowering unemployment. Finally, a
deterministic permanent increase in the steady-state level of both public va-
cancies and wages causes crowding out effect and increases unemployment.
However, most of the crowding out happens due to the public sector wage
increase, since, as seen in the graph an increase in steady-state public wages
increases unemployment more sharply than an increase in the steady-state
number of public vacancies.
31
6 Conclusion and Discussion
The paper was motivated by the newly issued 2017 salary scale that concerns
all public sector employees in Lebanon. This is done by using a two-sector
search and matching model in a deterministic framework.
Three permanent deterministic and uncorrelated shocks are considered.

The first being a technology shock, the second a public sector wages shock
and the third a public sector vacancies shock. Also, a temporary Total
Factor Productivity shock is considered. These affect private sector wages
through two different mechanisms: i) the crowding out effect that increases
the share of unemployed searching for a public sector job and thus increases
the marginal productivity of an additional worker in the private sector, ii)
the value of being unemployed, where a positive shock to public sector va-
cancies and wages increases the value of being employed in the public sector,
giving the unemployed an interesting alternative and putting pressure on the
bargaining power.
Results show that no matter what the circumstances are, a permanent

deterministic shock on public vacancies and wages crowds out the labour
market raising by that unemployment. This crowding out effect is amplified
when the economy is subject to negative temporary TFP shock since the
latter raises unemployment and thus further crowds out the market. Most of
the crowding out is caused by the increase in public sector wages, not public
sector vacancies. I also show that employment stimulus programs are ineffec-
tive under both positive and negative temporary TFP shocks. The only case
where the labour market succeeds to absorb the crowding effect of a public
employment stimulus program is when there is a permanent deterministic
technology shock. However, given the latter shock, not implementing the
stimulus policy would be optimal. These results clearly indicate that given
the tax policy in Lebanon, a government-based employment stimulus pro-
gram is ineffective and even harmful.
Moreover, I build a policy recommendation that examines the change in

the steady-state levels of the labour market variables in response to a change
in the steady state level of distortionary income tax, public sector wage pre-
mium, bargaining power and public sector matching efficiency. Results show
that an increase in steady-state tax levels has the greatest impact on the
labour market, lowering private sector employment and considerably raising
unemployment. On the other hand, and despite the crowding out effect it
creates, an increase in public sector matching efficiency successfully reduces
unemployment. This is a relevant extension since matching efficiency levels
obtained from steady state calculations are very low. Therefore, it would
be interesting to review the sectarian-based government’s recruitment pro-
32
gram known as the Civil Service Council. This approach could be the cause
behind the very low public sector matching efficiency. Further research is
needed in order to better understand the impact of the sectarian approach
on the Lebanese labour market.
Moreover, it would be valuable to substitute homogeneous workers by

heterogeneous ones in order to better understand the matching process and
the low matching efficiencies that could be due to a mismatch between
skills/education demand and offer. A rule linking public sector wages and
consumption based tax could be added, especially that, labour income tax
does not constitute a major player in the government’s revenues.
33
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7 Appendices
7.1 Steady State Tax Level Variation
Unconditional Job Finding Rate ConditionalJob Finding Rate Probability of Filling a Vacancy
Steady State Tax Level Steady State Tax Level Steady State Tax Level
Employment and Unemployment Number of Matches Number of Vacancies
Number of Unemployed Searching in Both Sectors Share of Unemployed Searching for a Public Sector Job Aggregate Consumption and Production
Wages Value of Employment and Unemployment Value of Employment and Unemployment
36
7.2 Steady State Public Sector Wage Premium Variation
Steady State Public Sector Wage Premium Level Steady State Public Sector Wage Premium Level Steady State Public Sector Wage Premium Level
37
7.3 Steady State Public Sector Matching Efficiency Varia-
tion
Steady State Public Sector Matching Efficiency Level Steady State Public Sector Matching Efficiency Level Steady State Public Sector Matching Efficiency Level
38
7.4 Steady State Bargaining Power Variation
Steady State Bargaining Power Level Steady State Bargaining Power Level Steady State Bargaining Power Level
Steady State Bargaining Power Level Steady State Tax Level Steady State Tax Level
39
7.5 Transition Path of the Economy in Response to a Per-
manent Deterministic Shock on Technology, Public Em-
ployment and Public Wages
Period Period Period
40
manent Deterministic Shock on Public Employment and
Public Wages
41
manent Deterministic Shock on Public Wages
42
manent Deterministic Shock on Public Vacancies
43
manent Deterministic Shock on Technology
44
7.10 Transition Path of the Economy in Response to a De-
terministic Temporary Shock on the Total Factor Pro-
ductivity
45
7.11 Transition Path of the Economy in Response to a Tem-
porary Deterministic Shock on the Total Factor Pro-
ductivity Augmented by a Permanent Deterministic
Shock on Public Vacancies and Wages
46
7.12 Transition Path of Unemployment in Response to Dif-
ferent Shocks
Transition of Unemployment Positive TFP VS Negative TFP shocks Transition of Unemployment Subject to Different Shocks
th Period Period
Transition of Unemployment Subject to Different Shocks
Period
Figure 5: The Transition Path of Unemployment Subject to: A Determinis-

tic positive TFP Shock Augmented by a Public Sector Vacancies and Wages
Shock (T F P, all), A Deterministic Negative TFP Shock Augmented by a
Public Sector Vacancies and Wages Shock (N egativeT F P, all), A Perma-
nent Deterministic Technology Shock (a), A Permanent Deterministic Shock
on Technology, Public Sector Vacancies and Wages (All), A Permanent De-
terministic Shock on Public Sector Vacancies and Wages (v g , wg ), A Perma-
nent Deterministic Shock on Public Sector Wages (wg ) and A Permanent
Deterministic Shock on Public Sector Vacancies (v g )
47
7.13 Transition Path of Private Sector Employment in Re-
sponse to Different Shocks
Transition of Private Employment Positive TFP VS Negative TFP shocks Transition of Private Employment Subject to Different Shocks
th Period Period
Transition of Private Employment Subject to Different Shocks
Period
Figure 6: The Transition Path of Private Employment Subject to: A Deter-

ministic positive TFP Shock Augmented by a Public Sector Vacancies and
Wages Shock (T F P, all), A Deterministic Negative TFP Shock Augmented
by a Public Sector Vacancies and Wages Shock (N egativeT F P, all), A Per-
manent Deterministic Technology Shock (a), A Permanent Deterministic
Shock on Technology, Public Sector Vacancies and Wages (All), A Perma-
nent Deterministic Shock on Public Sector Vacancies and Wages (v g , wg ),
A Permanent Deterministic Shock on Public Sector Wages (wg ) and A Per-
manent Deterministic Shock on Public Sector Vacancies (v g )
48
7.14 Transition Path of Public Sector Employment in Re-
sponse to Different Shocks
Transition of Public Employment Positive TFP VS Negative TFP shocks Transition of Public Employment Subject to Different Shocks
th Period Period
Transition of Public Employment Subject to Different Shocks
Period
Figure 7: The Transition Path of Public Employment Subject to: A Deter-

ministic positive TFP Shock Augmented by a Public Sector Vacancies and
Wages Shock (T F P, all), A Deterministic Negative TFP Shock Augmented
by a Public Sector Vacancies and Wages Shock (N egativeT F P, all), A Per-
manent Deterministic Technology Shock (a), A Permanent Deterministic
Shock on Technology, Public Sector Vacancies and Wages (All), A Perma-
nent Deterministic Shock on Public Sector Vacancies and Wages (v g , wg ),
A Permanent Deterministic Shock on Public Sector Wages (wg ) and A Per-
manent Deterministic Shock on Public Sector Vacancies (v g )
49
7.15 Transition Path of Private and Public Employment as
well as Unemployment in Response to a Negative TFP
Shock
Negative TFP Shock : Employment Stimulus Plan Vs No Plan, Public Emp Negative TFP Shock : Employment Stimulus Plan Vs No Plan, Private Emp
th Period Period
Negative TFP Shock : Employment Stimulus Plan Vs No Plan, Unemployment
Period
Figure 8: The Transition Path of Private and Public Employment as well as

Unemployment Subject to a Negative TFP Shock, The Case Of Employment
Stimulus Plan Versus No Plan.
50

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Modelling the 2017 Salary Scale in Lebanon: A

Search and Matching Approach

2 Lebanon’s Economic Environment 10

6 Conclusion and Discussion 32

Moreover, worldwide, compensations to employees occupy a significant

Numerous studies have considered compensation to employees as the

1. Frictionless Labor market models:

The paper finds that an increase in public employment increases un-

2. Search and matching models with the public sector :

The paper shows that in an RBC framework, shocks on government

Using the New-Keynesian Sticky Prices model, government expendi-

Burdett (2012) considers a model where the public sector is repre-

Michaillat (2014) introduces a search and matching model to a New

In their model, the error correction mechanism represents fric-

1.2 Research Paper Framework and Results

The job destruction rate is different between sectors and is determined

The increase in private wages results in a decrease in private employ-

In the simulation performed on Matlab, I start by varying the steady

Results show that an increase in the steady-state distortionary tax level

Additionally, the model shows that following a permanent deterministic

2.2 Lebanese Labour Market Facts

Limited to no data concern the dynamics of jobs creation and destruc-

In their brief policy in 2015, the International Labour Organization es-

According to the United Nation Development Program (UNDP), the es-

The agent in this economy is modelled via an infinitely lived household

Each individual or member of the household provides value to the house-

Private and public employment evolves according to a law of motion that

3.1 General Setting

The labour force is modelled by the following equation:

1 = ltp + ltg + u. (1)

The law of motion of employment in each of the two sectors sectors is :

It describes the evolution of employment. The share of employed in period

I adopt a constant return to scale Cobb-Douglas matching function since

The aim of the matching function is to pair unemployed workers with

The probability of filling a vacancy in sector i and time t is denoted as

mit i mit i mit

The members of the household receive an income that equalizes consump-

The objective function is the following:

it represents the expected lifetime utility for an infinitely-lived household

I use a logarithmic utility function 5 that belongs to the isoelastic utility

The household maximizes his utility subject to a budget constraint. This

ct + Bt = (1 + rt−1 )Bt−1 + (1 − τt )wtp ltp + (1 − τt )wtg ltg + zt ut + Πt (6)

As before, ct and Bt stand respectively for the consumption and bonds

The Lagrangian equation for the household problem is:

From the first order conditions 8 we obtain the Euler equation

It represents the solution to the above constrained maximization prob-

Uti = zt + Et βt,t+1 [pit Wt+1

Using the directed search assumption, unemployed members can search

Utp = Utg = Ut (12)

The optimality condition can also be written as :

In the above production function, at stands for technology at time t, α

Technology at follows an autoregressive process of order 1 with a drift.

at = ρat−1 + (1 − ρ)ā + at (15)

This equation represents the law of motion of technology, where, ρ stands

The objective of the firm is to maximize its present discounted value of

From the first order conditions9 we obtain:

3.5 Nash Bargaining and Private Sector Wage Determina-

9 ∂Lt ∂Lt p−α p

Jt = at (1 − α)ltp−α − wtp + Et βt,t+1 [(1 − λp )Jt+1 ] (22)

gt = at (ltg − θg vtg ) (24)

The unemployment benefit follows the progress of technology. This is

Notice that z is different from zt . The former is a parameter and stands

vtg = v̄ g + vt (27)

The model is calibrated at a quarterly frequency, the stochastic discount

at = ρat−1 + (1 − ρ)ā + at (15)

vtg = v̄ g + vt (27)