Choosing the pace of fiscal consolidation

Abstract

In many OECD countries debt has soared to levels threatening fiscal sustainability, necessitating its reduction over the medium to longer term. This paper proposes a stylised model, featuring endogenous interactions between fiscal policy, growth and financial markets, to highlight how economic shocks and structural features of an economy can affect consolidation strategy and resulting growth and inflation developments. The fiscal authorities are assumed to choose a consolidation path from a predetermined set of possible paths by maximising cumulative GDP growth and minimising cumulative squared output gaps, with the objective to reach a given debtto- GDP level within a finite horizon and stabilise debt afterwards under the assumption of the unchanged fiscal policy stance. Illustrative simulations for a hypothetical economy show, among other things, that by requiring debt to stabilise part of the initial adjustment can be reversed; some stepping up of the fiscal adjustment can be optimal if bond yields increase due to an exogenous shock; and for some debt reduction targets, high fiscal multipliers, hysteresis effects and higher government bond yields imply protracted deflation and large negative output gaps, stressing the need to select reasonable fiscal targets consistent with market conditions. JEL classification: E61, E62, H6 Keywords: Fiscal consolidation, sovereign debt, government budget balance, fiscal rules