Fiscal Consolidation Under Imperfect Credibility

69 Pages Posted: 25 Jul 2016

See all articles by Matthieu Lemoine

Matthieu Lemoine

Banque de France

Jesper Lindé

Sveriges Riksbank - Research Division

Multiple version iconThere are 3 versions of this paper

Date Written: July 2016

Abstract

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.

Keywords: Currency Union., DSGE model, Front-Loaded vs. Gradual Consolidation, Monetary and Fiscal Policy, Sticky Prices and Wages

JEL Classification: E32, F41

Suggested Citation

Lemoine, Matthieu and Linde, Jesper, Fiscal Consolidation Under Imperfect Credibility (July 2016). CEPR Discussion Paper No. DP11404, Available at SSRN: https://ssrn.com/abstract=2814079

Matthieu Lemoine (Contact Author)

Banque de France ( email )

Paris
France

Jesper Linde

Sveriges Riksbank - Research Division ( email )

S-103 37 Stockholm
Sweden
+46 8 787 0873 (Phone)

HOME PAGE: http://www.riksbank.com

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