Fiscal expansions, unemployment, and labor force participation: Theory and evidence

Structural VARs indicate that for many OECD countries labor force participation, employment, and the unemployment rate significantly increase following increases in government expenditures under a variety of specifications and identification schemes. Fiscal expansions also tend to increase real wages. Existing models have difficulties in generating such responses. We show that the empirical regularities can be reproduced with two additions into a standard New Keynesian model with matching frictions: (a) a labor force participation choice and (b) workers' heterogeneity.