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Fiscal consolidation in a currency union: Spending cuts vs. tax hikes

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  • Erceg, Christopher J.
  • Lindé, Jesper

Abstract

This paper uses a two country DSGE model to examine the effects of tax-based vs. expenditure-based fiscal consolidation in a currency union. We find three key results. First, given limited scope for monetary accommodation, tax-based consolidation tends to have smaller adverse effects on output than expenditure-based consolidation in the near-term, though is more costly in the longer-run. Second, a large expenditure-based consolidation may be counterproductive in the near-term if the zero lower bound is binding, reflecting that output losses rise at the margin. Third, a “mixed strategy” that combines a sharp but temporary rise in taxes with gradual spending cuts may be desirable in minimizing the output costs of fiscal consolidation.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 37 (2013)
Issue (Month): 2 ()
Pages: 422-445

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Handle: RePEc:eee:dyncon:v:37:y:2013:i:2:p:422-445

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Web page: http://www.elsevier.com/locate/jedc

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Keywords: Monetary policy; Fiscal policy; Liquidity trap; Zero bound constraint; Open economy macroeconomics; DSGE model;

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Citations

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Cited by:
  1. Florina-Cristina Badarau & Florence Huart & Ibrahima Sangaré, 2013. "Indebtedness and macroeconomic imbalances in a monetary-union DSGE model," Working Papers hal-00996622, HAL.
  2. Saroj Bhattarai & Jae Won Lee & Woong Yong Park, 2013. "Optimal monetary policy in a currency union with interest rate spreads," Globalization and Monetary Policy Institute Working Paper 150, Federal Reserve Bank of Dallas.
  3. Virkola, Tuomo, 2014. "Exchange Rate Regime, Fiscal Foresight and the Effectiveness of Fiscal Policy in a Small Open Economy," ETLA Reports 20, The Research Institute of the Finnish Economy.
  4. Reinhart, Carmen M. & Rogoff, Kenneth S., 2009. "The Aftermath of Financial Crises," Scholarly Articles 11129155, Harvard University Department of Economics.
  5. Javier Andrés & J.E. Boscá & Javier Ferri, 2014. "Instruments, rules and household debt: the effects of fiscal policy," Working Papers 1401, International Economics Institute, University of Valencia.
  6. Apostolis Philippopoulos & Petros Varthalitis & Vanghelis Vassilatos, 2013. "Optimal Fiscal Action in an Economy with Sovereign Premia and without Monetary Independence: An Application to Italy," CESifo Working Paper Series 4199, CESifo Group Munich.

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