Fiscal Consolidation in a Currency Union: Spending Cuts vs. Tax Hikes

57 Pages Posted: 5 Dec 2012

See all articles by Christopher J. Erceg

Christopher J. Erceg

Board of Governors of the Federal Reserve System

Jesper Lindé

Sveriges Riksbank - Research Division

Multiple version iconThere are 2 versions of this paper

Date Written: September 24, 2012

Abstract

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.

Keywords: E32, F41

JEL Classification: Monetary Policy, Fiscal Policy, Liquidity Trap, Zero Bound Constraint, Open Economy Macroeconomics

Suggested Citation

Erceg, Christopher J. and Linde, Jesper, Fiscal Consolidation in a Currency Union: Spending Cuts vs. Tax Hikes (September 24, 2012). FRB International Finance Discussion Paper No. 1063, Available at SSRN: https://ssrn.com/abstract=2184977 or http://dx.doi.org/10.2139/ssrn.2184977

Christopher J. Erceg (Contact Author)

Board of Governors of the Federal Reserve System ( email )

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Jesper Linde

Sveriges Riksbank - Research Division ( email )

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Sweden
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