Public and private sector wages interactions in a general equilibrium model

It is common wisdom that public sector wages are not determined in the same way as private sector wages. At the same time, the empirical evidence available for OECD countries finds a strong positive correlation between public and private sector wages. In this paper, we develop a model that is consistent with a political economy view of the determination of public sector wages and employment, while being consistent with the said empirical evidence. Public finance constraints are crucial: In booms, governments expand employment and wages, while in downturns, lack of tax revenues forces the government to cut back the wage bill.