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Fiscal Consolidation in a Low Inflation Environment: Pay Cuts versus Lost Jobs

Author

Listed:
  • Guilherme Bandeira

    (Bank of Spain)

  • Evi Pappa

    (European University Institute)

  • Rana Sajedi

    (Bank of England)

  • Eugenia Vella

    (Department of Economics, University of Sheffield)

Abstract

We construct a model of a monetary union to study fiscal consolidation in the Periphery of the Euro area, through cuts in public sector wages or hiring when the nominal interest rate is constrained at its lower bound. Consolidation induces a positive wealth effect that increases demand, as well as a reallocation of workers towards the private sector, which together boost private activity. However, in a low inflation environment, demand is suppressed and the private sector is not able to absorb the additional workers. Comparing the two instruments, cuts in public hiring increase unemployment persistently in this environment, while wage cuts can reduce it. Regions with higher mobility of labor between the two sectors are able to consolidate more effectively. Price flexibility is also key at the zero lower bound: for a higher degree of price rigidity in the Periphery, consolidation becomes harder to achieve. Consolidations can be self-defeating when the public good is productive.

Suggested Citation

  • Guilherme Bandeira & Evi Pappa & Rana Sajedi & Eugenia Vella, 2017. "Fiscal Consolidation in a Low Inflation Environment: Pay Cuts versus Lost Jobs," Working Papers 2017012, The University of Sheffield, Department of Economics.
    • Handle: RePEc:shf:wpaper:2017012
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    Cited by:

    1. Guilherme Bandeira & Jordi Caballe & Eugenia Vella, 2019. "Fiscal Austerity and Migration: A Missing Link," Working Papers 2019009, The University of Sheffield, Department of Economics.
    2. Pascal Jacquinot & Matija Lozej & Massimiliano Pisani, 2018. "Labor Tax Reforms, Cross-Country Coordination, and the Monetary Policy Stance in the Euro Area: A Structural Model-Based Approach," International Journal of Central Banking, International Journal of Central Banking, vol. 14(3), pages 65-140, June.
    3. Konstantinos Mavrigiannakis & Andreas Vasilatos & Eugenia Vella, 2023. "Fiscal Tightening and Skills Mismatch," DEOS Working Papers 2313, Athens University of Economics and Business.
    4. Juin‐Jen Chang & Hsieh‐Yu Lin & Nora Traum & Shu‐Chun S. Yang, 2021. "Fiscal Consolidation and Public Wages," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 53(2-3), pages 503-533, March.
    5. John Nana Francois & Andrew Keinsley, 2023. "Intratemporal elasticity of substitution between private and public consumption: new evidence and implications," Empirical Economics, Springer, vol. 65(4), pages 1655-1692, October.
    6. Alessio Moro & Omar Rachedi, 2022. "The Changing Structure Of Government Consumption Spending," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 63(3), pages 1293-1323, August.
    7. Edoardo Beretta & Doris Neuberger, 2023. "Monetary aggregates in the US since 2020 and post-COVID-19 inflation: evidence from the equation of exchange," Economics and Business Letters, Oviedo University Press, vol. 12(4), pages 321-330.
    8. Moro, Alessio & Rachedi, Omar, 2018. "The Changing Structure of Government Spending," MPRA Paper 86577, University Library of Munich, Germany.
    9. Bandeira, Guilherme & Caballé, Jordi & Vella, Eugenia, 2022. "Emigration and fiscal austerity in a depression," Journal of Economic Dynamics and Control, Elsevier, vol. 144(C).
    10. Guilherme Bandeira & Jordi Caballe & Eugenia Vella, 2020. "Emigration and Fiscal Austerity in a Depression," DEOS Working Papers 2035, Athens University of Economics and Business.

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    More about this item

    Keywords

    Fiscal Consolidation; Public Wage Bill; Zero Lower Bound;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory

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