How harmful are cuts in public employment and wage in times of high unemployment?

Abstract

AbstractSince 2010, and in line with austerity measures, public employment and public‐sector compensations to employees have been significantly reduced in most Euro Area member states and particularly in Spain and Greece. At the same time, unemployment in these two economies was greatly increasing. In a dynamic and stochastic general equilibrium (DSGE) model, we demonstrate that these cuts in public employment and wages are more damaging in terms of output and employment losses in periods of high unemployment. The model is able to produce significant state dependence of fiscal multipliers. Main results can be summarized as follows: (1) Public‐sector wages shocks produce larger multipliers than public‐sector employment shocks; (2) with a higher steady‐state unemployment, response of non‐Ricardian consumption to fiscal shocks are worse while Ricardian households consumption is better off, thanks to lower inflation following fiscal shocks and a higher marginal utility of consumption at the high‐unemployment steady state; (3) a larger share of non‐Ricardian households, a higher job separation rate, and a lower matching efficiency amplify fiscal multipliers; (4) a passive monetary policy increases fiscal multipliers in the case of public vacancy shocks but dampens multipliers associated with cuts in public‐sector wages; and (5) fiscal multipliers are larger when demand and supply shocks hit the economy, to a greater extent in the case of a negative shock on aggregate demand.