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We consider a dynamic general equilibrium model with capital accumulation and collective wage bargaining and investigate how unemployment responds to structural shocks under two stylised budgetary policies. Under balanced budgets, tax adjustments lead to higher unemployment on impact but enable a quick recovery of employment. By contrast, unbalanced budgets mitigate unemployment effects on impact but dynamics are more persistent due to weaker capital accumulation and future fiscal consolidations. These results are consistent with empirical evidence on a positive cross-country relationship between government borrowing and unemployment persistence. This paper starts out from the well-known fact that many European countries have suffered from persistently high unemployment over the past two decades. There is a large literature which attempts to explain this development as resulting from a combination of structural shocks and mechanisms which make the effects of any such shifts more persistent. One prominent branch of this literature stresses that adverse structural shocks tend to induce a slowdown in capital accumulation which reinforces the employment losses and adds to unemployment persistence (Bean, 1989;Benassy, 1997;Blanchard, 1997;Burda, 1988;Caballero and Hammour, 1998;Daveri and Tabellini, 2000). Similarly, these studies point out that, when the shock is over, the recovery of employment depends critically on the speed with which investments in capital respond to the new situation.The purpose of this paper is to reconsider this 'capital-shortage hypothesis' by linking it explicitly to the stance of fiscal policy. To see the importance of fiscal policy in this context, consider a government which faces an adverse structural shock (such as a drop in employment due to a wage-setting shock) and decides whether it should keep its budget balanced or not. This decision will affect the overall structure of assets in the economy (i.e. the mix between capital and government bonds), and this mix will in turn be an important determinant of the speed with which the economy can create employment once the shock is over. In particular, according to the capital-shortage hypothesis, the recovery in terms of employment is likely to take longer under a policy which temporarily accepts structural budget deficits, particularly when crowding out effects have been substantial.

We incorporate a wage bargaining structure in a dynamic general equilibrium model and show how this feature changes short and long-run properties of equilibria compared with a perfectly competitive setting. We discuss how employment, capital, and income shares respond to wage setting shocks and show that adjustment dynamics depend decisively on the magnitude of the elasticity of substitution between labour and capital. Values of the elasticity below unity add persistence, tend to preserve stability, and lead to empirically plausible adjustment patterns. By contrast, values above unity introduce additional volatility, thereby making steady states potentially unstable.

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