Budgetary Policy and Unemployment Dynamics

Abstract

We consider a dynamic general equilibrium model with collective wage bargaining and investigate how unemployment dynamics are affected by two types of budgetary policies. In line with traditional reasoning, a balanced-budget rule amplifies fluctuations in the short run, whereas an unbalanced-budget policy dampens them. However, the latter policy strengthens unemployment persistence by its adverse impact on growth, and may even destabilize the adjustment path. If this is the case, a future fiscal consolidation is needed which further raises unemployment. These results are consistent with empirical evidence on a positive cross-country relationship between government borrowing and unemployment persistence.