Fiscal consolidation in a low inflation environment: pay cuts versus lost jobs

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 11 November 2016

Working Paper No. 628
By Guilherme Bandeira, Evi Pappa, Rana Sajedi and Eugenia Vella

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 reduce it. Regions with higher mobility of labour 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 productive, or a complement to private consumption.

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