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Optimal Fiscal Consolidation Under Frictional Financial Markets

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  • Dejanir H Silva

Abstract

This paper studies optimal fiscal policy in a currency union subject to capital flow shocks in an economy with two main ingredients: (i) sticky prices and (ii) financially constrained arbitrageurs. Given capital outflows and high external debt, the fiscal authority faces a trade-off between stimulating the economy or paying off external debt. The planner reduces the value-added tax in the short run, while it raises and front-loads the sum of value-added tax and payroll taxes. It is not optimal to use spending to stimulate the economy. The country engages in a fiscal consolidation, as government debt falls compared with a passive fiscal policy.

Suggested Citation

  • Dejanir H Silva, 2023. "Optimal Fiscal Consolidation Under Frictional Financial Markets," The Economic Journal, Royal Economic Society, vol. 133(652), pages 1537-1585.
    • Handle: RePEc:oup:econjl:v:133:y:2023:i:652:p:1537-1585.
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    File URL: http://hdl.handle.net/10.1093/ej/uead013
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