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The paper studies the effects of fiscal expansion on the Japanese labor market. First, using a structural VAR model, we find that the unemployment rate falls and employment rises following an increase in government spending. We also find that fiscal expansion affects flows in and out of unemployment. While an increase in government spending increases the job-finding rate, it reduces the separation rate. We then incorporate search and matching frictions into a standard dynamic general equilibrium model, and study whether the model can explain what we observed in data. While the model fails to predict the exact size of the impact of government spending shocks on the Japanese labor market variables, it can consistently capture the empirical pattern of responses of labor market variables to shocks.

An important objective of fiscal policies is to boost output and to reduce unemployment in recessions. It is crucial to understand the effects of fiscal expansion on employment and unemployment, both empirically and theoretically. While there is an active debate on the effects of fiscal policies on the labor market among policy makers, the debate on fiscal policies among economists has rather focused on the size of the output and consumption multipliers of government spending. Recently, a number of studies investigate the effects of fiscal expansion on the labor market (Yuan and Li, 2000, Monacelli et al., 2010 and Brückner and Pappa, 2012). However, these studies mainly focus on the U.S., and less is known about the effects of fiscal expansion on labor markets in the other countries. Especially, there has no study on the Japanese case. Given the fact that Japan’s budget deficits and public debts have grown through the series of fiscal stimulus packages and also that Japan is the most indebted nation among OECD countries, it is crucial to examine the effectiveness of fiscal policies in the Japanese economy.1 In this paper, we study the effects of fiscal expansion on labor market dynamics in the Japanese economy both empirically and theoretically. Recently, Brückner and Pappa (2012) find that a fiscal expansion can lead to a significant increase in unemployment for many OECD countries by using a structural VAR model. Their seemingly paradoxical result has led to reconsideration of the impact of government spending on the labor market in the RBC and the New Keynesian models (Faia et al., 2013). In the first part of our analysis, we thus examine the effects of government spending on the Japanese labor market by using structural VAR models,2 to investigate to the extent how much the paradoxical result holds in Japan. In order to provide a detail on the transmission of fiscal policy to the labor market, we study the effects on variables such as the unemployment rate, inflow and outflow rates of unemployment, the intensive and extensive margins of work, labor force participation, vacancies, and the real wage. Furthermore, given the fact that government consumption and investment expenditures have behaved differently in the past 20 years in Japan, we differentiate between government’s purchases of consumption and investment goods in our empirical analysis. In contrast to Brückner and Pappa (2012), our empirical analysis demonstrates that an increase in government spending increases employment and vacancies posted, and reduces unemployment. These responses are accompanied by an increased outflow rate of unemployment and a decreased inflow rate of unemployment. Furthermore, our empirical analysis demonstrates that the effectiveness of fiscal policy in reducing unemployment in the post-2000s is larger than that in the pre-2000s. In the second part of our analysis, we develop a dynamic stochastic general equilibrium (DSGE) model with search frictions in the labor market and study the effects of fiscal expansion on the labor market. Specifically, we incorporate search and matching frictions à la Mortensen and Pissarides (1994) into a standard real business cycle model. Instead of assuming all government spending is wasteful as in the standard DSGE model, we assume that the government supplies goods that are of value to a household. Furthermore, we also distinguish between government consumption and productive government investment. The parameters in the model are calibrated to match certain facts of the Japanese economy. Our model can generate a similar pattern of responses of labor market variables to government spending shocks to that of SVAR models. The numerical analysis demonstrates that positive government spending shocks lead to a significant fall in the unemployment rate and increases in both vacancies and employment. Furthermore, our model succeeds in capturing empirical responses of private consumption to government spending shocks, which is in contrast with the standard DSGE model.3 This is because a negative wealth effect of fiscal expansion is mitigated by the incorporation of the government’s supply of goods that are of value to private sectors. While our model can qualitatively capture the empirical responses of labor market variables to government spending shocks, it quantitatively fails to predict the size of the impact of government spending shocks on labor market variables. For an increase in government consumption expenditures, the model generates enough magnitudes of the response of the unemployment rate and vacancies. However, for an increase in government investment expenditures, the model explains less than 40 percent of the observed impact of the fiscal shock on the unemployment rate. This study is related to the recent literature on fiscal effects on the labor market. Monacelli et al. (2010) study the effects of fiscal expansion on the U.S. labor market by developing a standard dynamic general equilibrium model with search frictions. While labor is adjusted along the extensive margin in their model, our model allows for an intensive margin of labor adjustment given the fact that the intensive margin accounts for much of total worked variation in Japan.4 In order to examine the effect of fiscal policy on the U.S. labor market, Yuan and Li (2000) develop a stochastic general equilibrium model with search frictions and both intensive and extensive margins. While in their model, labor supply decision is determined by households, in our model, hours worked are determined through bargaining between firms and workers. Brückner and Pappa (2012) find that for many OECD countries, positive government spending shocks increase the unemployment rate significantly by using structural VAR models and then explain the facts by using a standard New Keynesian model with search frictions and workers’ labor participation choices. In contrast to their studies, we show that an increase in government spending reduces the unemployment rate in Japan. Furthermore, we advance our understandings of government spending effects on the labor market by distinguishing between two of its components: government consumption and investment. This paper is also related to the recent literature on the effects of fiscal policy in the Japanese economy. A number of studies assess the effects of fiscal policy in Japan using DSGE models (Iwata, 2009; Fueki et al., 2010). While they focus on the effects of fiscal policy on macroeconomic variables such as output, consumption and investment, we focus on the effects of fiscal policy on the labor market. Thus, this paper complements these previous studies by investigating the effects of fiscal policy on labor market dynamics. The reminder of the paper is organized as follows. Section 2 presents the empirical results from structural VAR models. We also document some of salient features of the labor market and the fiscal situation in Japan. Section 3 develops a DSGE model with search frictions in the labor market. In Section 4, we calibrate the model parameters and present the quantitative results of the effects of fiscal expansion on the labor market. We also assess whether or not the results of our model depends on the assumption that the government supplies goods that are of value to a household. Section 5 concludes.

This paper studies the effects of fiscal expansion on labor market dynamics in the Japanese economy. First, we empirically study the effects of fiscal expansion on the Japanese labor market. We estimate a structural VAR model, distinguishing between government consumption expenditures and government investment expenditures. Our empirical analysis demonstrates that the unemployment rate falls and employment increases significantly following an increase in government expenditures. Given the fact that there exists a structural change in the Japanese labor market in the end of the 1990s, we also examine the effects of fiscal expansion on the labor market by taking into account the structural change. We then develop a dynamic stochastic general equilibrium (DSGE) model with labor market frictions. Instead of assuming all government spending is wasteful as seen in the standard DSGE model, we assume that the government supplies goods that are of value to a private sector. Furthermore, we distinguish between shocks on government consumption expenditures and shocks on government investment expenditure. The calibrated model can generate a similar pattern of responses of labor market variables to government spending shocks. Furthermore, the model also captures the empirical responses of consumption and investment to government spending shocks. A number of important issues remain unanswered. One issue to be considered is incorporating non-Ricardian consumers into the model. Our model assumes infinitely-live households and thus the Ricardian equivalence holds. Since most of the Japanese are now seriously concerned with negative effects and risks of the piled-up fiscal deficits, it is worth extending our model by incorporating non-Ricardian consumers. Also, considering a more realistic fiscal setup with distortionary taxes is an important issue. In our model, the government relies on lump-sum taxes. It is worth exploring how the economy with a realistic fiscal setup responds to a distortionary fiscal policy, in the form of not just a spending shock but also a tax shock.