Fiscal Consolidation in a Small Euro-Area Economy
by Vanda Almeida, Gabriela Castro, Ricardo Mourinho Félix, and José R. Maria
Banco de Portugal
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.
JEL Codes: E62, F41, H63.
Full article (PDF, 38 pages 929 kb)