The Effects of Government Spending in Segmented Labor and Financial Markets

Dusan Stojanovic

CERGE-EI Working Papers from The Center for Economic Research and Graduate Education - Economics Institute, Prague

Abstract: This paper develops a model with high-skilled and low-skilled workers to show the expansionary effects of government spending despite large training costs for new hires. The main idea is that a fiscal stimulus induces changes in the composition of the labor force conditional on the extent of aggregate demand pressure. A period of high aggregate demand pressure is followed by a high value of forgone output as training activity causes production disruption. In this period firms decide to hire more low-skilled workers, who constitute a cheaper part of the labor force. When aggregate demand pressure is diminished, firms switch to hiring more high-skilled workers. However, the current literature considers only high-skilled workers, who tend to increase saving in government bonds to protect against poor employment prospects. In this case, the combination of weak employment prospects and the crowding-out effects of higher lump-sum taxes and government debt on private consumption and capital investment gives rise to recessionary effects. In contrast, this paper provides a model with a more realistic labor and financial market structure and suggests that countercyclical government spending in the form of government consumption and especially government investment can be used to deal with recessions.

Keywords: Government spending; training cost; search and match frictions; financial friction (search for similar items in EconPapers)
JEL-codes: E22 E24 E32 E62 (search for similar items in EconPapers)
Date: 2023-03
New Economics Papers: this item is included in nep-dge and nep-mac
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