EC-IILS Joint Discussion Paper Series No. 8

Active labour market policies, search costs and positive fiscal multiplier

This paper discusses the efficiency of fiscal intervention. In particular, this paper models a new instrument for fiscal policy, active labour market policies, and identifies a new transmission channel for fiscal policy, the labour market. In the model below, active labour market policies play a key role in supporting new jobs, by easing the matching process between searching workers and firms with job vacancies. For that purpose, the traditional matching function is extended to incorporate labour market spending. The Cobb-Douglas matching function is now made of three elements: searching workers, vacancies and active labour market spending. There are ambivalent transmission channels. Fiscal spending crowds out private consumption and investment in line with the Ricardian properties associated with intertemporal optimizing private agents. The increase in the interest rate following fiscal expansion also affects negatively the discounted value of an additional match and reduces the incentive for firms to hire an additional worker. Labour market spending however improves the functioning of the labour market and increases the rate of matching.