The Macroeconomic Effects of Fiscal Consolidation in Dynamic General Equilibrium

We provide a systematic analysis of the transmission mechanisms of fiscal consolidation via various fiscal instruments in a medium-scale dynamic general equilibrium model. Our analysis shows that the following three aspects have a large impact on the quantitative macroeconomic effects of fiscal consolidation. First, the effects on output depend crucially on the interaction of the specific fiscal consolidation instrument with the production factors labor, private and public capital. Increases in the labor and capital tax rates and cuts in government investment lead to large declines in one of these production factors, respectively. This is followed by a decrease in the private or public capital stock which in turn yields a persistent output contraction. By contrast, for consolidations via government consumption, transfers or the consumption tax rate the capital stock does not shrink and output recovers much faster. Second, the presence of credit-constrained households amplifies the consumption and output dynamics caused by fiscal consolidation. This has large distributional consequences and opposing welfare implications for credit-constrained and fully optimizing households. Finally, when the zero lower bound on the nominal interest rate binds the short-run output costs of fiscal consolidation increase substantially in particular for expenditure based consolidations.