This paper primarily investigates the effects of a public sector wage shock using a DSGE model with search and matching frictions in a heterogeneous labour market composed of skilled and unskilled workers. The model is parametrized to reflect the South African labour market. The findings show that a public sector wage shock mainly crowds out private skilled labour which private firms substitute with unskilled workers. Overall unemployment increases in the short term as additional skilled workers queue for public jobs. Given unions high bargaining power, the public wage premium further applies upward pressures on private sector wages, which in turn contributes to rigidities in wages and subsequently to labour shedding in the private sector when economic activity is soft.
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