In the first years of the 1990s, Panama’ s economy strongly recovered from the deep crisis at the end of the previous decade. The government implemented a stabilization programme and initiated a reform process geared at economic liberalization in the spirit of those implemented throughout Latin America. The surge in capital inflows was the key factor underlying the boom in private consumption and in construction investment, which drove the high growth performance. This allowed for a reduction of unemployment and an increase of wage employment in the formal sector of the economy. Both these labour market outcomes were conducive of a reduction in urban poverty and inequality between 1991 and 1994. Growth slowed down and poverty stabilized during the period of economic reforms implemented between 1994 and 1998, but urban inequality increased again. Applying an innovative method of counterfactual microsimulations,the paper shows that the reduction of both urban and rural poverty and inequality between 1990 and 1997 was principally due to the macroeconomic effects that led to higher rates of economic participation and employment. This positive impact of macroeconomic effects was partially offset by that of the changes in the structure of the labour market, in particular the shift towards greater demand for skilled labour relative to unskilled labour and a rise in the share of informal sector employment. These labour market adjustments associated with the process of trade liberalisation and other economic reforms had the effect of a rise in inequality.