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Time-Varying Employment Risks, Consumption Composition, and Fiscal Policy
Abstract
This study examines the response of aggregate consumption to active labor market policies that reduce unemployment. We develop a dynamic general equilibrium model with heterogeneous agents and uninsurable unemployment as well as policy regime shocks to quantify the consumption effects of policy. By implementing numerical experiments using the model, we demonstrate a positive effect on aggregate consumption even when the policy serves as a pure transfer from the employed to the unemployed. The positive effect on consumption results from the reduced precautionary savings of the households who indirectly benefit from the policy by a decreased unemployment hazard in future.
Introduction
The impact of the recent recession on the labor market was so severe that the unemployment rate in the U.S. is still above normal and the duration of unemployment remains unprecedentedly large. There is a growing interest in labor market policies as effective macroeconomic policy instruments to combat such high unemployment (Nie and Struby (2011)) that has been used conservatively to help the unemployed. Two major questions presented in this literature are as follows: (i) What is the effect of the policy on the labor market performance of program participants? and (ii) What is the general equilibrium consequence of such policy? While there have been extensive microeconometric evaluations and discussions that have led to a consensus on the first question, the second question is unanswered because the indirect effects of the programs on nonparticipants via general equilibrium adjustments are inconclusive. Heckman, Lalonde and Smith (1999) pointed out that the commonly used partial equilibrium approach implicitly assumes that the indirect effects are negligible and can therefore produce misleading estimates when the indirect effects are substantial. Moreover, Calmfors (1994) investigated several indirect effects, and concluded that microeconometric estimates merely provide partial knowledge about the entire policy impact of such programs.