Fiscal stimulus and labor market dynamics in Japan

•Effects of fiscal expansion on the Japanese labor market are studied.•SVAR shows that an increase in government spending reduces unemployment.•A dynamic stochastic general equilibrium model with search frictions is developed.•The model captures the empirical pattern of labor market responses to fiscal shocks.

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.