Do Government Purchases Affect Unemployment?

AuthorVictoria Sparrman,Steinar Holden
Date01 January 2018
DOIhttp://doi.org/10.1111/sjoe.12214
Published date01 January 2018
©The editors of The Scandinavian Journal of Economics 2016.
Scand. J. of Economics 120(1), 124–158, 2018
DOI: 10.1111/sjoe.12214
Do Government PurchasesAffect
Unemployment?*
Steinar Holden
University of Oslo, NO-0317 Oslo, Norway
steinar.holden@econ.uio.no
Victoria Sparrman
Statistics Norway, NO-0033 Oslo, Norway
victoria.sparrman@ssb.no
Abstract
We estimate the effect of government purchases on unemployment in 20 OECD countries,
for the period 1980–2007. An increase in government purchases, equal to 1 percent of
GDP, is found to reduce unemployment by about 0.3 percentage points in the same
year. The effect is greater and more persistent under less “employment-friendly” labour-
market institutions, and it is greater and more persistent under a fixed exchange rate
regime than under a floating regime. The effect is also greater in downturns than in
booms. The effect on unemployment reflects a corresponding positive effect of increased
government purchases on the employment-to-population rate.
Keywords: Fiscal policy; unemployment
JEL classification:E62; H3
I. Introduction
During the financial crisis, most OECD countries used fiscal measures
extensively to stimulate the economy. More recently, increasing public
debt and rising default premia on sovereign debt have led to substantial
fiscal tightening in many countries. At the same time, unemployment
soared in many OECD countries. The large changes in fiscal policy
and unemployment rates raise the question of how fiscal policy affects
unemployment. In this paper, we explore an important part of fiscal policy:
the effect of a change in government purchases of goods and services
on aggregate unemployment.
*We are grateful to Roel Beetsma, Erik Biørn, Ådne Cappelen, Francesco Furlanetto, Nils
Gottfries, Tarjei Havnes, Ragnar Nymoen, Hashem Pesaran, Asbjørn Rødseth, Thomas Von
Brasch, Fredrik Wulfsberg, and two anonymous referees, as well as numerous seminar
participants, for very useful comments. The paper is part of the research activities at Statistics
Norway and ESOP at the University of Oslo. ESOP and Statistics Norway are supported by
the Research Council of Norway.
S. Holden and V. Sparrman 125
The effect of fiscal policy on the economy has been subject to
considerable interest in recent years; see surveys in Auerbach et al. (2010),
Beetsma and Giuliodori (2010), and Ramey (2011). The bulk of this
literature has dealt with the effect of fiscal policy on GDP, while the
body of literature exploring the effect on unemployment is much smaller.
This distinction is important because the effect on unemployment might
differ from the effect on GDP. Fiscal actions can lead to an increase
in the labour supply and increased unemployment, even if output grows.
Alternatively, if cuts in government purchases induce higher private-sector
output, and productivity is higher in the private sector, GDP can grow even
if unemployment increases. This ambiguity is reflected in recent research.
While Monacelli et al. (2010), IMF (2010), Auerbach and Gorodnichenko
(2012b), and Ramey (2012) conclude that an increase in government
purchases leads to lower unemployment, Br¨uckner and Pappa (2012) find
that increased government purchases lead to higher unemployment as a
result of increased labour-force participation.
Our study differs from most of the previous studies along several
dimensions. First, because our interest is in the effect on unemployment,
we draw upon a large body of literature, associated with, among others,
Layard et al. (1991), Blanchard and Wolfers (2000), and Nickell et al.
(2005), which has documented the importance of labour-market institutions
to the evolution of the rate of unemployment. Our analysis builds on this
body of literature, as we add the change in government purchases to
a regression framework designed to explore the effect of institutional
and other determinants of unemployment. This also allows us to explore
whether the effect of fiscal policy depends on labour-market institutions.
Furlanetto (2011) explores theoretically the link between fiscal stimulus
and wage rigidity, and shows that, if labour markets are segmented,
wage stickiness is essential to obtain the expansionary effects of fiscal
actions.
Second, we use an extensive panel dataset for 20 OECD countries for
the period 1980–2007, which makes it possible to explore whether the
effect of fiscal policy depends on a host of other factors, such as the
cyclical situation of the economy, the type of fiscal impulse, etc. A number
of recent papers argue that the effect of fiscal policy depends crucially
on the possible monetary response (e.g., Eggertson and Woodford, 2003;
Hall, 2009; Coenen et al., 2012); we explore this idea by considering
how the effect differs across monetary regimes.
An important methodological problem is that fiscal policy is likely to be
endogenous, as it might depend on the state of the economy. Restricting
attention to government purchases mitigates this problem, because, unlike
taxes and transfers, there are no automatic links between the state of the
economy and government purchases. We handle possible endogeneity by
©The editors of The Scandinavian Journal of Economics 2016.
126 Do government purchases affect unemployment?
using instrumental variables (IV), and by controlling for possible additional
variables that can affect both fiscal policy and unemployment.
We find that an increase in gover nment purchases, equal to 1 percent
of GDP, leads to a first-year reduction in the rate of unemployment of
about 0.3 percentage points, with a somewhat larger effect when we use
an IV estimator. The effect increases somewhat in the second year, and
then decreases gradually, vanishing after eight years. The size of the effect
is highly dependent on other factors in the economy. We find a greater
effect on unemployment in countries with labour-market institutions that
are less conducive to employment. Consistent with the recent research
mentioned above, we find a strong effect of fiscal policy on unemployment
in countries with a fixed exchange rate, and a weaker effect under a
floating exchange rate. There is also evidence suggesting that the change
in unemployment due to a rise in government purchases is greater when
the economy is in a downturn, which is consistent with recent findings
by Auerbach and Gorodnichenko (2012a,b), and Nakamura and Steinsson
(2014). We find a positive effect of increased government purchases on
the employment to population rate, which corresponds to the negative
effect on unemployment.
The rest of the paper is organized as follows. In Section II, we present
our empirical approach, the data are presented in Section III, while the
empirical results are laid out in Sections IV–VIII. Section IX concludes. An
Online Appendix contains further descriptions of the data, the underlying
theoretical model, and additional results.
II. Empirical Model and Estimation Methods
Weconsider the effect of a change in government purchases on unemployment
and employment, building on a panel data estimation framework derived
by Nymoen and Sparrman (2014), who consider a dynamic model with
wage and price setting. They derive a final equation for equilibrium
unemployment as a function of labour-market institutions and unmodelled
shocks.1We replace the shocks by a fiscal variable and an indicator for
the export market.
This approach has several advantages. First, an extensive body of literature
has shown that aggregate unemployment is, to a large extent, determined
by labour-market institutions (e.g., Layard et al., 1991; Nickell et al.,
2005). Thus, it seems appropriate to control for labour-market institutions,
and to also investigate whether the effect of fiscal policy depends on these
institutions. Second, with a dataset covering 20 countries and 27 years,
there is large variation in a number of other key variables, making it
1A simplified version of Nymoen and Sparrman (2014) is provided in the Online Appendix.
©The editors of The Scandinavian Journal of Economics 2016.

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