Fiscal Consolidation in a Low Inflation Environment: Pay Cuts Versus Lost Jobs

Abstract

We construct a model of a monetary union to study fiscal consolidation in the periphery of the euro area, through cuts in public-sector wages or hiring when the nominal interest rate is constrained at its lower bound. Consolidation induces a positive wealth effect that increases demand, as well as a reallocation of workers towards the private sector, which together boost private activity. However, in a low-inflation environment, demand is suppressed and the private sector is * We would like to thank the editor, L. Reichlin, and an anonymous referee for their comments, as well as A. Trigari for the insightful discussion. We are also grateful for comments to R. Wouters and other participants in the International Journal of Central Banking Research Conference 2017 and in the "Fiscal Policy after the Crisis" workshop organized by the European Commission. We would also like to thank A

Should I Stay or Should I Go? Austerity, Unemployment and Migration

“…In particular, we consider fiscal consolidations implemented via cuts in public expenditures, cuts in unemployment benefits, or increases in labor income tax rates. Fiscal consolidation is modeled as a negative shock to the debt target, in a fashion similar to Erceg and Lindé (2013), Pappa et al (2015) and Bandeira et al (2018). Our findings indicate that a tax-based consolidation induces the highest migration outflows in the short run, which exacerbates significantly the induced GDP contraction.…”

“…whereb is the steady state debt-to-GDP level and ε b t is a white noise process representing a fiscal consolidation shock. We therefore consider a gradual (effectively permanent) reduction in the target for the debt-to-GDP ratio (see also Erceg and Lindé (2013), Pappa et al (2015), Bandeira et al (2018)). As we explain below, for the fiscal rule (30), we calibrate the set of three parameters for each fiscal instrument in such a way that the actual debt-to-GDP ratio meets the new, lower target at the same time across the different instruments.…”

Fiscal Consolidation and Public Wages

“…4 Bermperoglou et al (2017) show that complementarity between private consumption and public services can influence whether public wages are expansionary or contractionary. In addition, Ardagna (2007), Pappa (2009), and Bandeira et al (2018) show that the results are dependent on whether public services enter the private production function. Taking advantage of our Bayesian approach, we perform model comparisons to evaluate the relative quantitative performance of these alternative channels through utility-enhancing public services and productive public services.…”

“…Traditionally, the literature on government spending effects focuses on goods purchases. In light of the increasing importance of government compensation, several recent studies have examined its macroeconomic implications (e.g., Quadrini and Trigari (2007), Afonso and Gomes (2014), Gomes (2015), Pérez et al (2016), Bermperoglou et al (2017), Bradley et al (2017), and Bandeira et al (2018)). 1 Relative to these works, we estimate with Bayesian inference methods a New Keynesian model that includes both public compensation and government purchases of goods, an exercise heretofore not pursued in the literature.…”

“…In specification 3, we consider productive public services, such as maintaining law and order, that may raise private productivity. Following Ardagna (2007), Pappa (2009), and Bandeira et al (2018), we allow public services to enter 22 Kormilitsina and Zubairy (2016) also do not find support for utility enhancing public goods in an estimated model with S&L and federal U.S. data that abstracts from modeling public compensation. the private production function by modifying equation 2as…”