DP12310 Fiscal Consolidations in a Low Inflation Environment:Pay cuts versus Lost Jobs

Author(s): Guilherme de Almeida Bandeira, Evi Pappa, Rana Sajedi, Eugenia Vella
Publication Date: September 2017
Keyword(s): fiscal consolidation, Public Wage Bill, zero lower bound
JEL(s): E32, E62
Programme Areas: International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=12310

We construct a model of a monetary union to study fiscal consolidation in the Periphery of the Euro area, through cuts in public sector wages or hiring when the nominal interest rate is constrained at its lower bound. Consolidation induces a posi- tive wealth effect that increases demand, as well as a reallocation of workers towards the private sector, which together boost private activity. However, in a low inflation environment, demand is suppressed and the private sector is not able to absorb the additional workers. Comparing the two instruments, cuts in public hiring increase un- employment persistently in this environment, while wage cuts can reduce it. Regions with higher mobility of labor between the two sectors are able to consolidate more effectively. Price flexibility is also key at the zero lower bound: for a higher degree of price rigidity in the Periphery, consolidation becomes harder to achieve. Consolidations can be self-defeating when the public good is productive.