Working Paper BETA #2015-16

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

Author(s) : Thierry Betti, Thomas Coudert

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.

Key-words : Labor Market Search, Wage Bargaining, PublicWage, Business Cycle, Fiscal Policy, Second Order.

JEL Classification : E62, J38.