DP7526 Fiscal Policy Can Reduce Unemployment: But There is a Better Alternative

Author(s): Roger E A Farmer

Publication Date: November 2009

Keyword(s): Financial crisis , Fiscal policy , Unemployment

JEL(s): E24 , E44

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP7526.asp

This paper uses a model with a continuum of equilibrium unemployment rates to explore the effectiveness of fiscal policy. The existence of multiple steady states is explained by a model of costly search and recruiting that leads to a situation of bilateral monopoly. Using this framework, I explain the current financial crisis as a shift to a high unemployment equilibrium, induced by the self-fulfilling beliefs of market participants about asset prices. Using this model, I ask two questions. 1) Can fiscal policy help us out of the crisis? 2) Is there an alternative to fiscal policy that is less costly and more effective? The answer to both questions is yes.