Universität Mannheim / VWL / Priority Programme 1578 / Navigation / Projects / Fiscal Consolidation in Times of Financial Stress: Theory and Evidence

Fiscal Consolidation in Times of Financial Stress: Theory and Evidence

Coordinator: Prof. Gernot Müller, Ph.D.

Participants: Florian Kirsch,  Patrick Hürtgen

We investigate how fiscal consolidation affects economic activity in times of financial stress. Measures of fiscal consolidation include the reduction of government spending and transfer payments as well as tax increases. Such measures are currently enacted in many OECD countries and further measures are likely to be observed in coming years as governments attempt to reign in public debt. The notion of “times of financial stress” is meant to capture a situation where 1) borrowing costs of governments and/or private agents are high because of increased default risk and 2) the conduct of monetary policy is constrained by the zero lower bound on policy rates. While standard models and most empirical studies suggest that fiscal consolidation is detrimental to economic activity in normal times, i.e. in a situation where borrowing costs are low and monetary policy is unconstrained, the consequences of consolidation in times of financial stress are less well understood. We therefore assess, both theoretically and empirically, the hypothesis that the consequences of fiscal consolidation in times of financial stress differ from its consequences in normal times. In order to do so, we develop tools which allow us to account for state dependence of the effects of fiscal policy measures. First, we specify and solve a quantitative business cycle model with state dependence due to default risk and constraints on monetary policy. Second, we estimate a regime transition vector autoregression model on time-series data from OECD countries. In line with our theoretical work and in order to capture the distinct features of financial stress, we allow for different regimes defined on the basis of observable measures such as sovereign debt ratings, a broad index measure of financial stress, and the level of monetary policy rates.

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