I build a dynamic stochastic general equilibrium model with search and matching frictions
in order to study the labour market effects of public sector employment and wages. Public
sector wages are important to achieve the efficient allocation. High wages induce too many unemployed
to queue for public sector jobs, raising unemployment. Following technology shocks,
public sector wages should be procyclical and deviations from the optimal policy increase the
volatility of unemployment significantly. Another conclusion is that different types of fiscal
shocks have opposite effects on labour market variables. I then estimate the parameters of the
model for the United States.