We provide a systematic analysis of the transmission of fiscal consolidation via various instruments in a medium-scale dynamic general equilibrium model. Our results show that in the short run fiscal consolidation leads to a large and persistent contraction in output if the fiscal instrument affects production factors negatively as it is the case for government investment cuts and labor and capital tax increases. By contrast, for a consolidation via government consumption, transfers or the consumption tax rate, output recovers much faster. The presence of credit-constrained households who cannot smooth consumption amplifies overall output dynamics. In addition, we show that the welfare of credit-constrained households is more adversely affected by fiscal consolidation than welfare of unconstrained households irrespective of the fiscal instrument used. 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.
- Distortionary taxes
- fiscal consolidation
- government debt
- monetary-fiscal policy interaction
- zero lower bound