Debt Targets and Fiscal Consolidation in a two-country HANK model for the Euro Area

53 Pages Posted: 1 Feb 2023 Last revised: 13 Apr 2023

See all articles by Xiaoshan Chen

Xiaoshan Chen

Durham University

Spyridon Lazarakis

Lancaster University

Petros Varthalitis

Athens University of Economics and Business

Date Written: January 31, 2023

Abstract

This paper builds a two-country Heterogenous Agents New Keynesian (HANK) model for the Euro Area (EA). The two countries differ in the degree of public indebtedness, i.e., the Periphery has a relatively higher public debt-output ratio vis-à-vis the Core. The model captures some key features of the EA's cross- and within-country heterogeneity over the 2010-2020 period. We use this model as a vehicle to study fiscal consolidation policy and reforms of EA fiscal targets. We find that public debt asymmetry can explain qualitatively, and to some extent quantitatively, EA macroeconomic imbalances and within-country disparities. We find that a fiscal consolidation scenario that mimics the current EA institutional arrangements, i.e., the Maastricht Treaty and the Stability Growth Pact Agreement, would result in significant welfare losses, especially for the wealth-poor and wealth-median in the Periphery; the welfare losses amount to 2.42% and 2.21% of their lifetime consumption in the status quo stationary equilibrium, respectively. A revision of EA fiscal targets closer to their current values, e.g., 100% for the Periphery and 70% for the Core, does not generate a conflict of interest between wealth-rich and -poor households across and within countries. Thus, our analysis provides a strong rationale for reforming EA debt targets. Such reform could make more affordable fiscal consolidation for the large proportion of households in the Periphery, e.g., it reduces the welfare losses from 2.42% to 1.24% for the wealth-poor households in the Periphery. Surprisingly, a Core expansion (i.e., a higher public debt-output ratio) while the Periphery consolidates would not benefit a large proportion of households in the Periphery, especially those with relatively fewer asset holdings in the status quo stationary equilibrium. Such a reform generates a conflict of interest between the Core's households and the wealth-poor/median households in the Periphery. Furthermore, a hawkish monetary policy reaction against inflation during fiscal consolidation generates a conflict of interest between the wealth-rich in the union and the wealth-poor households in the Periphery. Such policy disproportionately benefits households who hold more assets in the status quo equilibrium. Regarding fiscal policy mix, fiscal consolidation via spending cuts instead of tax hikes disproportionally harms the households with relatively higher asset holdings in the status quo stationary equilibrium, but it is less harmful for the wealth-poor households in the Periphery.

Keywords: Fiscal Consolidation, Debt Targets, Monetary Policy, Inequality, Welfare

JEL Classification: E21, H31, E52, E62, H50

Suggested Citation

Chen, Xiaoshan and Lazarakis, Spyridon and Varthalitis, Petros, Debt Targets and Fiscal Consolidation in a two-country HANK model for the Euro Area (January 31, 2023). Available at SSRN: https://ssrn.com/abstract=4343870 or http://dx.doi.org/10.2139/ssrn.4343870

Xiaoshan Chen

Durham University

Spyridon Lazarakis

Lancaster University ( email )

Lancaster LA1 4YX
United Kingdom

Petros Varthalitis (Contact Author)

Athens University of Economics and Business ( email )

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