Prescott, 2005). The results are reported in figure 3 below.
[Figure 3 about here]
As in the comparative statics exercise of the previous section, we let the public spending compo-
sition change from its 1976-80 value, G1/c = 0.29 and G2/c = 0.07, to its 1987-91 value G1/c = 0.26
and G2/c = 0.18. This time though, the change from the initial to the final period will take place
gradually according to (24). In the figure, we can see how the trajectories of government spending,
which represent our policy shock, evolve, and the effect they produce on the endogenous variables
of the model.34 All responses of endogenous variables to the policy shock are in line with what we
found in the steady-state analysis in proposition 2, and in its quantitative application in the previous
section. More precisely, the high-tech arrival rate of innovation increases and then, as the high-tech
R&D difficulty increases, slowly returns to the exogenous steady-state level n∕μ. The education choice
mechanism implies that in equilibrium the employment of skilled workers increases as well. The low-
tech sector shows a similar dynamics but in the opposite direction. These shifts in employment imply
that the relative employment of unskilled workers, θ0 (t), decreases. Contemporary to skill upgrading,
as the composition of public spending rises, the relative wage of skilled workers increases, thus qualita-
tively reproducing the dynamics of the skill premium observed in the data. The speed of convergence
looks very slow because we have approximated continuous time with a large number of discrete sub-
periods. Of course the aim of this transitional dynamics exercise is merely to show that qualitatively
realistic tra jectories can be generated by our fully rational general equilibrium model.
8 Conclusions
In this paper we have shown that the technological content of government spending played a significant
role in explaining the wave of innovations that hit the US economy in recent decades and its effects on
the wage structure. The interaction between policy and the heterogeneous industry structure yields
the basic theoretical contribution of the paper: a shift in the composition of public spending towards
highly innovative sectors increases aggregate expenditure in innovation and the skill premium.
We identify and quantify the role of a new source of technical change, the technological composition
of public spending, which complements the role of international trade (Dinopoulos and Segerstrom
1999 and Acemoglu 2003) and of the relative supply of skills (Acemoglu 1998 and 2002b, and Kiley
1998) in endogenizing the factor bias of technical change.35 In a calibrated version of the model we
show that the shift of US public spending toward more innovative industries can explain between 12
and 15 percent of the observed increase in the skill premium between 1976 and 1991.
This paper represents a first attempt to evaluate the effects of fiscal policy on technology and wages
and is amenable to many extensions. First, further research could be devoted to fill the data gap that
34 Here we have set our unit of time to 1 because simulating the model for many periods improves the convergence
properties of the solution algorithm.
35 It is worth stressing once again that our model is not, strictly speaking, a model of skill-biased technical change.
However, introducing endogenous factor-bias in the set-up and assuming that high-tech goods are produced by skilled
workers and low-tech goods by unskilled workers, the composition of government spending would have the same qualitative
effects on inequality.
20