Discussion Paper Details

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

Author(s): Christopher Erceg and Jesper Lindé

Publication Date: September 2012

Keyword(s): DSGE Model, Fiscal Policy, Liquidity Trap, Monetary Policy, Open Economy Macroeconomics and Zero Bound Constraint

Programme Area(s): International Macroeconomics

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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Bibliographic Reference

Erceg, C and Lindé, J. 2012. 'Fiscal Consolidation in a Currency Union: Spending Cuts vs. Tax Hikes'. London, Centre for Economic Policy Research.