| Abstract | A dynamic stochastic general equilibrium model is built to determine the optimal public sector wage and employment. A panel estimate of 23 provinces over 1991-2012 and VAR analysis indicates China’s public employment is consistent with the long-run relationship predicted by the theoretical model. Following business cycle, public sector wages should be pro-cyclical while employment should be counter-cyclical; policy simulation demonstrates that deviations from the optimal policy significantly increase the volatility of unemployment and output. With regard to development, quantile regression technique is applied here to show that the optimal cyclical public employment policy may benefit middle income group and reduce earnings inequality; by incorporating public employment in an overlapping generations framework, welfare analysis implies that under the optimal policy, current generations don’t suffer much losses from external shocks, however, welfare cost might be increasing in the future due to a rise in tax or a cut in transfers. |