Fiscal Consolidation in a Low-Inflation Environment: Pay Cuts versus Lost Jobs
by Guilherme Bandeiraa, Evi Pappab, Rana Sajedic, and Eugenia Vellad
We construct a model of a monetary union to study fiscal
consolidation in the periphery of the euro area, through
cuts in public-sector wages or hiring when the nominal interest
rate is constrained at its lower bound. Consolidation induces
a positive wealth effect that increases demand, as well as
a reallocation of workers towards the private sector, which
together boost private activity. However, in a low-inflation
environment, demand is suppressed and the private sector is not able to absorb the additional workers. Comparing the two
instruments, cuts in public hiring increase unemployment persistently
in this environment, while wage cuts can reduce it.
Regions with higher mobility of labor between the two sectors
are able to consolidate more effectively. Price flexibility is also
key at the zero lower bound: for a higher degree of price rigidity
in the periphery, consolidation becomes harder to achieve.
Consolidations can be self-defeating when the public good is
JEL Code: E32, E62.
Full article (PDF, 46 pages, 1739 kb)
Discussion by Antonella Trigari
a Banco de España
b European University Institute
c Bank of England
d University of Sheffield