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

Guilherme Bandiera (), Evi Pappa (), Rana Sajedi and Eugenia Vella ()
Additional contact information
Guilherme Bandiera: European University Institute, Postal: European University Institute
Eugenia Vella: University of Sheffield, Postal: University of Sheffield

No 628, Bank of England working papers from Bank of England

Abstract: 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.

Keywords: Fiscal consolidation; public wage bill; zero lower bound (search for similar items in EconPapers)
JEL-codes: E32 E62 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-dge, nep-eec and nep-mac
Date: 2016-11-11
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Related works:
Journal Article: Fiscal Consolidation in a Low-Inflation Environment: Pay Cuts versus Lost Jobs (2018) Downloads
Working Paper: Fiscal Consolidations in a Low Inflation Environment:Pay cuts versus Lost Jobs (2017) Downloads
Working Paper: Fiscal Consolidation in a Low Inflation Environment: Pay Cuts versus Lost Jobs (2017) Downloads
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