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

Listed author(s):
  • Thierry Betti
  • Thomas Coudert

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.

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Paper provided by Bureau d'Economie Théorique et Appliquée, UDS, Strasbourg in its series Working Papers of BETA with number 2015-16.

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Date of creation: 2015
Handle: RePEc:ulp:sbbeta:2015-16
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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," IMF Working Papers 05/159, International Monetary Fund.
  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. Kai Christoffel & James Costain & Gregory de Walque & Keith Kuester & Tobias Linzert & Stephen Millard & Olivier Pierrard, 2009. "Inflation dynamics with labour market matching : assessing alternative specifications," Working Paper Research 164, National Bank of Belgium.
  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. 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.
  9. 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, 01.
  10. 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, 09.
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