A heterogeneous agent new Keynesian model of search frictions and public sector employment

I study how public sector employment affects aggregate output and employment. Although accounting for approximately 25% of the labour force in modern economies, the macroeconomic effects of public sector employment remain largely underexplored. I build a Heterogeneous Agent New Keynesian (HANK) model with unemployment risk, endogenous job destruction, sluggish vacancy creation, and public sector employment. This is the first HANK model to study this fiscal tool, allowing me to capture key labour dynamics and assess their joint role with unemployment risk in shaping the effectiveness of policy shocks. Calibrated to France, the model shows that public sector employment lowers unemployment and increases aggregate output with multipliers above unity, driven by (i) stronger demand, (ii) labour frictions limiting crowding out, and (iii) reduced unemployment risk –effects that decline in the absence of labour and nominal frictions, and disappear in a representative agent setup. Finally, compared to an increase in benefits, public sector employment is more effective in stimulating economic activity and welfare.