The effects of public spending shocks on the labor market: Focus on households' preference

This paper deals with the effects of public spending shocks on the labor market in the short term. A growing literature in macroeconomics attempts to estimate the size of the unemployment fiscal multiplier and to investigate the channel transmissions of the fiscal policy on the labor market. The goal of the present paper is to contribute to this recent literature by focusing on the labor supply and on the households’ preferences in a theoretical framework.

The core of the paper is a medium-scale DSGE (Dynamic and Stochastic General Equilibrium) model with a detailed fiscal sector including public consumption and public investment. The model follows closely Gali, Smets and Wouters (2012) and allows obtaining the unemployment rate as an observable variable. The financing of the spending can be tax-based (taxes on consumption and wages) or debt-based.

Both financing mechanisms are analyzed and I compute the fiscal multipliers on GDP and on unemployment. A large part of the paper is dedicated to a sensitivity analysis. The aim is to check the robustness of the results to changes on the model parameters values. I focus on the parameters introduced in the households’ parameters, namely the elasticity of substitution of the labor supply, the degree of habit formation for consumption and the size of the wealth effect of the consumption on the labor supply decision. Since I allow for different kinds of funding, I also investigate the effects of the two taxes introduced in the model.

The main findings are: 1) I find strong negative fiscal multipliers with rapport to the literature. A shock of the public consumption (corresponding to 1% of GDP) decreases the unemployment rate by 0.6% and a similar public investment shock decreases unemployment by about 1%. 2) The results are robust to changes in the parameters values concerning the households’ preferences. I cannot find with this model positive unemployment fiscal multipliers contrary to recent papers. These results are more sensitive to deep parameters like nominal rigidities and to parameters driving the labor demand 3) The tax on consumption has a positive effect on the labor supply, decreasing the unemployment fiscal multiplier and a tax on wages has the opposite effect, hiking the total effect on unemployment.