DP9052 A Theory of Countercyclical Government-Consumption Multiplier

Author(s): Pascal Michaillat
Publication Date: July 2012
Keyword(s): business cycle, multiplier, unemployment
JEL(s): E24, E32, E62
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9052

This paper proposes a dynamic stochastic general equilibrium model in which the government-consumption multiplier doubles when unemployment rises from 5% to 8%. Theoretically, such countercyclicality arises because of a nonlinearity, namely, that labor supply is convex in a labor market tightness-employment diagram. In the model, as government consumption increases, public employment rises, stimulating labor demand. Equilibrium tightness increases, which reduces private employment and partially offsets the increase in public employment. Since labor supply is convex, the increase in tightness is small in recessions but large in expansions. Hence, government consumption reduces unemployment much more in recessions than in expansions.