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How can the labor market accounts for the effectiveness of fiscal policy over the business cycle?

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  • Thierry BETTI
  • Thomas COUDERT

    () (LaRGE Research Center, Université de Strasbourg)

Abstract

We develop a new-Keynesian model with a two-sector search and matching labor market framework. We investigate the first and second order effects of fiscal policy on labor market and on output. The model includes four fiscal instruments: a labor income tax, a social protection tax paid by firms, public wage and public vacancies. First-order simulations of the model indicate that whatever instrument is used, fiscal expansion significantly increases total employment and reduce unemployment. We explicit the different transmission channels at work. The main contribution is to use a second-order approximation of the model to investigate the effects of fiscal shocks for two states of the economy: a low unemployment state (6%) and a high unemployment state (12%). For the four fiscal instruments, response of employment is greater when the steady-state unemployment rate is high. We also emphasize a new channel for explaining a larger output fiscal multiplier in periods of economic downturn: the wage channel that plays a crucial role for explaining the non-linear effects of fiscal policy.

Suggested Citation

  • Thierry BETTI & Thomas COUDERT, 2015. "How can the labor market accounts for the effectiveness of fiscal policy over the business cycle?," Working Papers of LaRGE Research Center 2015-06, Laboratoire de Recherche en Gestion et Economie (LaRGE), Université de Strasbourg.
  • Handle: RePEc:lar:wpaper:2015-06
    as

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    References listed on IDEAS

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    1. Günter Coenen & Roland Straub, 2005. "Does Government Spending Crowd in Private Consumption? Theory and Empirical Evidence for the Euro Area," International Finance, Wiley Blackwell, vol. 8(3), pages 435-470, December.
    2. Christoffel, Kai & Kuester, Keith & Linzert, Tobias, 2009. "The role of labor markets for euro area monetary policy," European Economic Review, Elsevier, vol. 53(8), pages 908-936, November.
    3. Christoffel, Kai & Costain, James & de Walque, Gregory & Kuester, Keith & Linzert, Tobias & Millard, Stephen & Pierrard, Olivier, 2009. "Inflation dynamics with labour market matching: assessing alternative specifications," Working Paper Series 1053, European Central Bank.
    4. Alan J. Auerbach & Yuriy Gorodnichenko, 2012. "Fiscal Multipliers in Recession and Expansion," NBER Chapters,in: Fiscal Policy after the Financial Crisis, pages 63-98 National Bureau of Economic Research, Inc.
    5. Pascal Michaillat, 2014. "A Theory of Countercyclical Government Multiplier," American Economic Journal: Macroeconomics, American Economic Association, vol. 6(1), pages 190-217, January.
    6. Schmitt-Grohe, Stephanie & Uribe, Martin, 2004. "Solving dynamic general equilibrium models using a second-order approximation to the policy function," Journal of Economic Dynamics and Control, Elsevier, vol. 28(4), pages 755-775, January.
    7. Antonella Trigari, 2006. "The Role of Search Frictions and Bargaining for Inflation Dynamics," Working Papers 304, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
    8. William B. Peterman, 2016. "Reconciling Micro And Macro Estimates Of The Frisch Labor Supply Elasticity," Economic Inquiry, Western Economic Association International, vol. 54(1), pages 100-120, January.
    9. Frank Smets & Raf Wouters, 2003. "An Estimated Dynamic Stochastic General Equilibrium Model of the Euro Area," Journal of the European Economic Association, MIT Press, vol. 1(5), pages 1123-1175, September.
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    More about this item

    Keywords

    Labor Market Search; Wage Bargaining; Public Wage; Business Cycle; Fiscal Policy; Second Order.;

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • J38 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Public Policy

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