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Fiscal Compact and Debt Consolidation Dynamics

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Abstract

We analyse the macroeconomic effects of a debt consolidation policy in the Euro Area mimicking the Fiscal Compact Rule (FCR). The rule requires the signatory states to target a debt-to-GDP ratio below 60%. Within the context of Dynamic Stochastic General Equilibrium models (DSGE), we augment a fully micro-founded New-Keynesian model with a parametric linear debt consolidation rule, and we analyse the effects on the main macroeconomic aggregates. To fully understand its implications on the economy, we study different debt consolidation scenarios, allowing the excess debt to be re-absorbed with different timings. We show that including a debt consolidation rule can exacerbate the effects of the shocks in the economy by imposing a constraint on the public debt process. Secondly, we note that the effect of loosening or tightening the rule in response to a shock is heterogeneous. Shocks hitting nominal variables (monetary policy shock) are not particularly sensitive. On the contrary, we prove that the same change has a more pronounced effect in case of shock hitting real variables (productivity and public spending shocks). Finally, we show that the macroeconomic framework worsens as a function of the rigidity of the debt consolidation rule. As a limiting case, we show that the effects on output, employment, real wages, inflation, and interest rates are sizable.

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  • Luca Brugnolini & Luisa Corrado, 2018. "Fiscal Compact and Debt Consolidation Dynamics," CEIS Research Paper 436, Tor Vergata University, CEIS, revised 06 Nov 2018.
    • Handle: RePEc:rtv:ceisrp:436
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    1. Oręziak Leokadia, 2018. "Fiscal federalism and a separate budget for the euro area," International Journal of Management and Economics, Warsaw School of Economics, Collegium of World Economy, vol. 54(2), pages 85-98, June.

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    JEL classification:

    • E10 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - General
    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory

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