Working Paper Series no. 595: Fiscal Consolidation Under Imperfect Credibility

Abstract

This paper examines the effects of expenditure-based fiscal consolidation when credibility as to whether the cuts will be long-lasting is imperfect. We contrast the impact limited credibility has when the consolidating country has the means to tailor monetary policy to its own needs, with the impact when the country is a small member of a currency union with a negligible effect on interest rates and on nominal exchange rates of the currency union. We find two key results. First, in the case of an independent monetary policy, the adverse impact of limited credibility is relatively small, and consolidation can be expected to reduce government debt at a relatively low output cost given that monetary policy provides more accommodation than it would under perfect credibility. Second, the lack of monetary accommodation under currency union membership implies that the output cost may be significantly larger, and that progress in reducing government debt in the short and medium term may be limited under imperfect credibility.

Matthieu Lemoine and Jesper Lindé
May 2016

Classification JEL : E32, F41.

Keywords : monetary and fiscal policy, front-loaded vs. gradual consolidation, DSGE model, sticky prices and wages, currency union.