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Fiscal consolidation in the euro area - long-run benefits and short-run costs

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Author Info
Günter Coenen () (Directorate General Research, European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
Matthias Mohr () (Directorate General Economics, European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
Roland Straub () (Directorate General International and European Relations, European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)

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Abstract

In this paper, we examine the macroeconomic effects of alternative fiscal consolidation policies in the New Area-Wide Model (NAWM), a two-country open-economy model of the euro area developed at the European Central Bank (cf. Coenen et al., 2007). We model fiscal consolidation as a permanent reduction in the targeted government debt-to-output ratio and analyse both expenditure and revenue-based policies that are implemented by means of simple fiscal feedback rules. We find that fiscal consolidation has positive long-run effects on key macroeconomic aggregates such as output and consumption, notably when the resulting improvement in the budgetary position is used to lower distortionary taxes. At the same time, fiscal consolidation gives rise to noticeable short-run adjustment costs in contrast to what the literature on expansionary fiscal consolidations suggests. Moreover, depending on the fiscal instrument used, fiscal consolidation may have pronounced distributional effects. JEL Classification: E32, E62.

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Paper provided by European Central Bank in its series Working Paper Series with number 902.

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Length: 48 pages
Date of creation: May 2008
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Handle: RePEc:ecb:ecbwps:20080902

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Related research
Keywords: DSGE modelling; limited asset-market participation; fiscal policy; fiscal consolidation; euro area.;

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  1. Günter Coenen & Roland Straub, 2005. "Does Government Spending Crowd in Private Consumption? Theory and Empirical Evidence for the Euro Area," International Finance, Blackwell Publishing, vol. 8(3), pages 435-470, December. [Downloadable!] (restricted)
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  2. Silvia Ardagna & Francesco Caselli & Timothy Lane, 2005. "Fiscal Discipline and the Cost of Public Debt Service: Some Estimates for OECD Countries," CEP Discussion Papers dp0670, Centre for Economic Performance, LSE. [Downloadable!]
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  3. Richard Morris & Hedwig Ongena & Ludger Schuknecht, 2006. "The reform and implementation of the Stability and Growth Pact," Occasional Paper Series 47, European Central Bank. [Downloadable!]
  4. Tamim Bayoumi & Douglas Laxton & Paolo Pesenti, 2004. "Benefits and spillovers of greater competition in Europe: a macroeconomic assessment," Staff Reports 182, Federal Reserve Bank of New York. [Downloadable!]
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  5. Francesco Giavazzi & Marco Pagano, 1990. "Can Severe Fiscal Contractions be Expansionary? Tales of Two Small European Countries," NBER Working Papers 3372, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  6. Jordi Galí & J. David López-Salido & Javier Vallés, 2007. "Understanding the Effects of Government Spending on Consumption," Journal of the European Economic Association, MIT Press, vol. 5(1), pages 227-270, 03. [Downloadable!] (restricted)
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  7. Francesco Giavazzi & Marco Pagano, 1996. "Non-Keynesian Effects of Fiscal Policy Changes: International Evidence and the Swedish Experience," NBER Working Papers 5332, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  8. Günter Coenen & Peter McAdam & Roland Straub, 2007. "Tax reform and labour-market performance in the euro area - a simulation-based analysis using the New Area-Wide Model," Working Paper Series 747, European Central Bank. [Downloadable!]
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  9. Noriaki Kinoshita, 2006. "Government Debt and Long-Term Interest Rates," IMF Working Papers 06/63, International Monetary Fund. [Downloadable!]
  10. Doris Prammer, 2004. "Expansionary Fiscal Consolidations? An Appraisal of the Literature on Non-Keynesian Effects of Fiscal Policy and a Case Study for Austria," Monetary Policy & the Economy, Oesterreichische Nationalbank (Austrian Central Bank), issue 3, pages 35-52, October. [Downloadable!]
  11. Roberto Perotti, 1999. "Fiscal Policy In Good Times And Bad," The Quarterly Journal of Economics, MIT Press, vol. 114(4), pages 1399-1436, November. [Downloadable!] (restricted)
  12. Thomas Laubach, 2003. "New evidence on the interest rate effects of budget deficits and debt," Finance and Economics Discussion Series 2003-12, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  13. Christopher J. Erceg & Luca Guerrieri & Christopher Gust, 2006. "SIGMA: a new open economy model for policy analysis," International Finance Discussion Papers 835, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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