A Political Economy Theory of Fiscal Policy and Unemployment

This paper presents a political economy theory of fiscal policy and unemployment. The underlying eco-nomic model is one in which unemployment can arise but can be mitigated by tax cuts and public spending increases. Such policies are fiscally costly, but can be financed by issuing government debt. Policy deci-sions are made by a legislature consisting of representatives from different political districts. The theory provides a positive account of the simultaneous determination of fiscal policy and unemployment. The most important implication of the theory is that debt and unemployment levels should be positively cor-related. Some evidence in support of this prediction is provided using data from a panel of developed countries.