Research Discussion Papers, Bank of Finland
The role of labour markets in fiscal policy transmission
Abstract: This paper shows how frictions in the labour market shape
the responses of the economy to government spending shocks. The open
economy New Keynesian DSGE model is extended by labour market frictions of
the Mortensen-Pissarides type and a detailed description of fiscal policy.
The nature of offsetting fiscal measures is found to be critical for the
effects of fiscal stimulus, due to the different effects of different tax
instruments on the labour market. Specifically, shifting the
debt-stabilizing burden towards distortionary labour taxes has detrimental
effects on the labour market outcome and on overall economic performance in
a flexible wage regime. The results show that wage rigidity increases the
effectiveness of fiscal policy in the short term but leads to a worse
longer term result including unemployment exceeding steady state levels.
The analysis suggests that a closer look at the functioning of labour
markets may help to identify fiscal policy transmission channels not
captured by the standard New Keynesian model.
Keywords: search frictions; wage bargaining; wage and price rigidity; fiscal rules; debt stabilization; (follow links to similar papers)
JEL-Codes: E62; J41; (follow links to similar papers)
72 pages, August 5, 2011
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