Fiscal Consolidation and Public Wages

A New Keynesian model with government production, public compensation, and unemployment is fit to U.S. data to study the effects of public wage reductions. Estimation implies reductions in public wages and government goods purchases have similar effects on total output, and the fiscal balance, yet the former can raise private output slightly, while the latter does not. Exogenous public wage reductions decrease private wages. Model counterfactuals show that sufficiently rigid nominal private wages can reverse the private wage response, as the rigidity dampens the labor reallocation effect from the public to private sector that exerts downward pressure on private wages.