Working Paper: CEPR ID: DP9155
Authors: Christopher Erceg; Jesper Lind
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: DSGE model; fiscal policy; liquidity trap; monetary policy; open economy macroeconomics; zero bound constraint
JEL Codes: E32; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Tax increases (H29) | Output (Y10) |
| Expenditure-based consolidation (H69) | Output (Y10) |
| Binding ZLB exacerbates Expenditure-based consolidation (E62) | Output (Y10) |
| Mixed strategy (temporary tax increases + gradual spending cuts) (E63) | Output (Y10) |
| Fiscal strategies tailored to monetary policy environment (E63) | Effectiveness of fiscal measures (E62) |