DP9155 Fiscal Consolidation in a Currency Union: Spending Cuts vs. Tax Hikes
|Author(s):||Christopher Erceg, Jesper Lindé|
|Publication Date:||September 2012|
|Keyword(s):||DSGE Model, Fiscal Policy, Liquidity Trap, Monetary Policy, Open Economy Macroeconomics, Zero Bound Constraint|
|Programme Areas:||International Macroeconomics|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=9155|
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.