Fiscal Policy in an Unemployment Crisis

Abstract

This article shows that equilibrium unemployment dynamics can significantly increase the efficacy of fiscal policy. In response to a shock that brings the economy into a liquidity trap, an expansion in government spending increases output and causes a fall in the unemployment rate. Since movements in unemployment are persistent, the effects of current spending prevail into the future, leading to an enduring rise in income. As an enduring rise in income boosts private demand, an increase in government spending sets in motion a virtuous employment-spending spiral with large effects on macroeconomic aggregates.