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International Finance Discussion Papers
The International Finance Discussion Papers logo links to the International Finance Discussion Papers home page Fiscal Consolidation in a Currency Union: Spending Cuts vs. Tax Hikes
Christopher J. Erceg and Jesper Linde
2012-1063  (November 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.

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Monetary policy, fiscal policy, liquidity trap, zero bound constraint, open economy macroeconomics, DSGE model

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