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

  • Erceg, Christopher J.
  • Lindé, Jesper

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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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
DOI: 10.1016/j.jedc.2012.09.012
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