Fiscal consolidation in a disinflationary environment: price vs. quantity-based measures

Abstract

An important feature of the current economic conditions in the EU, which challenges the design and implementation of macroeconomic policy, is inflation uncertainty. With monetary policy at the zero lower bound, and inflation well below its target, a key issue for policy makers is the effect /nthis has on the transmission of fiscal policy. We aim to address this question, in particular comparing the effects of price-based and quantity-based fiscal instruments. In this paper we focus on the public wage bill, and consider a model of a monetary union in which the government can /nconsolidate their debt through reductions in the public wage or public employment. We find that in both cases the low inflation environment eliminates the expansionary effects of the reduction in the public wage bill for the private sector. The drag in economic activity is substantially amplified/nin the low inflation environment, with increased debt-to-GDP levels during the consolidation process.