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Debt targets and fiscal consolidation in a two country HANK model: the case of Euro Area

Xiaoshan Chen (), Spyridon Lazarakis and Petros Varthalitis
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Xiaoshan Chen: Durham University
Spyridon Lazarakis: Lancaster University

No 2023_02, Working Papers from Department of Economics, University of Durham

Abstract: This paper builds a two-country Heterogenous Agents New Keynesian (HANK) model for the Euro Area (EA). The two countries differ in the degree of public indebtedness, i.e., the Periphery has a relatively higher public debt-output ratio vis-a-vis the Core. The model captures some key features of the EA ís cross- and within-country heterogeneity over the 2010-2020 period. We use this model as a vehicle to study fiscal consolidation policy and reforms of EA fiscal targets. We find that public debt asymmetry can explain qualitatively, and to some extent quantitatively, EA macroeconomic imbalances and within-country disparities. We find that a fical consolidation scenario that mimics the current EA institutional arrangements, i.e., the Maastricht Treaty and the Stability Growth Pact Agreement, would result in significant welfare losses, especially for the wealth-poor and wealth-median in the Periphery; the welfare losses amount to 2.42% and 2.21% of their lifetime consumption in the status quo stationary equilibrium, respectively. A revision of EA fiscal targets closer to their current values, e.g., 100% for the Periphery and 70% for the Core, does not generate a conflict of interest between wealth-rich and -poor households across and within countries. Thus, our analysis provides a strong rationale for reforming EA debt targets. Such reform could make more affordable fiscal consolidation for the large proportion of households in the Periphery, e.g., it reduces the welfare losses from 2.42% to 1.24% for the wealth-poor households in the Periphery. Surprisingly, a Core expansion (i.e., a higher public debt-output ratio) while the Periphery consolidates would not benefit a large proportion of households in the Periphery, especially those with relatively fewer asset holdings in the status quo stationary equilibrium. Such a reform generates a conflict of interest between the Core ís households and the wealth-poor/median households in the Periphery. Furthermore, a hawkish monetary policy reaction against inflation during fiscal consolidation generates a conflict of interest between the wealth-rich in the union and the wealth-poor households in the Periphery. Such policy disproportionately benefits households who hold more assets in the status quo equilibrium. Regarding fiscal policy mix, fiscal consolidation via spending cuts instead of tax hikes disproportionally harms the households with relatively higher asset holdings in the status quo stationary equilibrium, but it is less harmful for the wealth-poor households in the Periphery

Date: 2023-02
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