DP11404 Fiscal Consolidation Under Imperfect Credibility

Author(s): Matthieu Lemoine, Jesper Lindé
Publication Date: July 2016
Keyword(s): Currency Union, DSGE model, Front-Loaded vs. Gradual Consolidation, Monetary and Fiscal Policy, Sticky Prices and Wages
JEL(s): E32, F41
Programme Areas: International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11404

This paper examines the effects of expenditure-based fiscal consolidation when credibility as to whether the cuts will be long-lasting is imperfect. We contrast the impact limited credibility has when the consolidating country has the means to tailor monetary policy to its own needs, with the impact when the country is a small member of a currency union with a negligible effect on interest rates and on nominal exchange rates of the currency union. We find two key results. First, in the case of an independent monetary policy, the adverse impact of limited credibility is relatively small, and consolidation can be expected to reduce government debt at a relatively low output cost given that monetary policy provides more accommodation than it would under perfect credibility. Second, the lack of monetary accommodation under currency union membership implies that the output cost may be significantly larger, and that progress in reducing government debt in the short and medium term may be limited under imperfect credibility.