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

JEL(s): E32 , F41

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP9155.asp

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.