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Fiscal consolidation in a small euro area economy
This article focuses on the costs and benefits of a fiscal consolidation in a small euro area economy. The macroeconomic impacts and the welfare analysis are conducted in a New-Keynesian general equilibrium model with non-Ricardian agents. We define a benchmark fiscal consolidation strategy based on a permanent reduction in Government expenditure. We find that, over the long run, fiscal consolidation leads to a considerable increase in the level of output and consumption, and is welfare improving. In addition, the gains are boosted if the fiscal strategy also involves a tax reform that shifts the tax burden away from labour income towards the final goods consumption. However, important short-run costs arise, notably through output, consumption and welfare losses. Finally, we assess the effect of alternative fiscal consolidation paths in terms of its degree of front loading, speed of completion and interaction with the risk premium.