Fiscal Consolidation in a Small Euro Area Economy

This article focuses on macroeconomic impacts and welfare effects of a fiscal consolidation process in a small euro-area economy. Fiscal consolidation is defined as a permanent decline in the ratio of public debt to GDP. The analysis is based on PESSOA, a New Keynesian general equilibrium model with non-Ricardian agents. The results suggest that a reduction in public expenditure leads in the long run to sizable increases in output and tends to improve welfare, specifically because it allows for a sustainable decrease in the labor income tax rate. However, output and consumption decline in the short run, and current generations are likely to experience welfare losses. This situation might well provide a rationale for the frequent lack of political will to move in this direction. The results are robust to alternative paths for fiscal consolidation.