Employment prospects and the propagation of fiscal stimulus

Abstract

I study a novel channel that amplifies the effects of a rise in government purchases. To explore the mechanism, I use a model with uninsured idiosyncratic risk, frictional labor market and sticky prices. Fiscal stimulus increases aggregate demand and boosts job creation. The latter improves employment prospects by reducing unemployment risk faced by households. This, in turn, weakens precautionary motives and raises private consumption which strengthens the initial fiscal impulse. Quantitative analysis indicates that magnitude of the employment prospects channel is substantial: without this mechanism, crowding out of aggregate consumption associated with higher government expenditures is three times larger. Interestingly, in contrast to many recent works using heterogeneous agent models, the analyzed channel does not rely on behavior of liquidity constrained, hand-to-mouth agents.