Fiscal Consolidations in a Low Inflation Environment: Pay Cuts Versus Lost Jobs

49 Pages Posted: 26 Sep 2017

See all articles by Guilherme Bandeira

Guilherme Bandeira

Banco de España

Evi Pappa

European University Institute; Universidad Carlos III de Madrid, Faculty of Social Sciences and Law, Department of Economics, Students; Autonomous University of Barcelona - MOVE (Markets, Organizations and Votes in Economics); Barcelona Graduate School of Economics (Barcelona GSE)

Rana Sajedi

Bank of England

Eugenia Vella

Athens University of Economics and Business

Date Written: September 2017

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 can reduce it. Regions with higher mobility of labor 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.

Keywords: fiscal consolidation, Public Wage Bill, zero lower bound

JEL Classification: E32, E62

Suggested Citation

Bandeira, Guilherme and Pappa, Evi and Pappa, Evi and Sajedi, Rana and Vella, Eugenia, Fiscal Consolidations in a Low Inflation Environment: Pay Cuts Versus Lost Jobs (September 2017). CEPR Discussion Paper No. DP12310, Available at SSRN: https://ssrn.com/abstract=3042620

Guilherme Bandeira (Contact Author)

Banco de España ( email )

Alcala 50
Madrid 28014
Spain

Evi Pappa

European University Institute ( email )

Fiesole, Tuscany
Italy

HOME PAGE: http://www.eui.eu/Personal/Pappa/

Universidad Carlos III de Madrid, Faculty of Social Sciences and Law, Department of Economics, Students ( email )

Calle Madrid 126
Getafe, 28903
Spain

HOME PAGE: http://https://sites.google.com/site/evipappapersonalhomepage/home

Autonomous University of Barcelona - MOVE (Markets, Organizations and Votes in Economics) ( email )

Campus de Bellaterra-UAB Edifici B (s/n)
EDIFICI B
Cerdanyola del Vallès
, Barcelona 08193
Spain

Barcelona Graduate School of Economics (Barcelona GSE) ( email )

Ramon Trias Fargas 25-27
Barcelona, Catalonia 08014
Spain

Rana Sajedi

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Eugenia Vella

Athens University of Economics and Business ( email )

No Address Available

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