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Fiscal Consolidation in a Currency Union: Spending Cuts vs. Tax Hikes

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  • Erceg, Christopher
  • Lindé, Jesper

Abstract

This paper uses a two country DSGE model to examine the effects of tax-based versus 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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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 9155.

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Date of creation: Sep 2012
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Handle: RePEc:cpr:ceprdp:9155
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Keywords: DSGE Model; Fiscal Policy; Liquidity Trap; Monetary Policy; Open Economy Macroeconomics; Zero Bound Constraint;

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Find related papers by JEL classification:
  • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
  • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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