Fiscal Consolidation in an Open Economy with Sovereign Premia and without Monetary Policy Independence
by Apostolis Philippopoulosa,b, Petros Varthalitisc and Vanghelis Vassilatosa
We welfare rank various tax-spending-debt policies in a
New Keynesian model of a small open economy featuring sovereign
interest rate premia and loss of monetary policy independence.
When we compute optimized state-contingent policy
rules, our results are as follows: (i) Debt consolidation comes
at a short-term pain, but the medium- and long-term gains can
be substantial. (ii) In the early phase of pain, the best fiscal
policy mix is to cut public consumption spending to address
the debt problem and, at the same time, to cut income tax
rates to mitigate the recessionary effects of debt consolidation.
(iii) In the long run, the best way of using the fiscal space
created is to reduce capital taxes.
JEL Codes: E6, F3, H6.
Full article (PDF, 48 pages, 424 kb)
a Athens University of Economics and Business
c Economic and Social Research Institute, Trinity College Dublin