Thursday, 11 March 2010

Fiscal consolidation at the zero interest lower bound

Here I scratch the surface of a more general question: the effects of Fiscal consolidation at the zero interest lower bound which is not far from where the EMU and US short term interest rates are right now. This suggests that what we should debate is Fiscal consolidation at the zero interest lower bound and not Fiscal consolidation tout-court. In the last two years Macroeconomists have (re)-learned that in a liquidity trap the fiscal multiplier is at maximum and larger than in normal times. Therefore elasticities estimated in samples that do not contain periods of near zero interest rates might not be reliable for near-liquidity trap periods. This observation has another implication: if fiscal multipliers are larger when interest rates are close to the zero lower bound, fiscal consolidation should be performed during times when the economy is far from the lower bound. Wait, it becomes worse: at the zero interest rate lower bound, the larger contractionary effect of fiscal policy increases the probability of maintaining the interest rates at zero, making it more difficult to escape from the trap. There are many caveats, the most obvious regard interest rates payments on national debt (the longer we wait the larger are the payments) and credibility. Let me conclude by suggesting that the escape from near-zero interest rate lower bound in a monetary union necessarily involves an increase in aggregate demand in the monetary union. This would suggest to have fiscal consolidation plans contingent with the EMU recovery and monetary policy normalization.


  1. I somewhat agree with your conclusion but that doesn't mean that the increase in the aggregate demand should be equally shared by all emu members, simply because those countries were in very diferent situations regarding their fiscal and external positions.

    However I struggle to fully follow your argument about the effect of interest zero lower bound on the semi-elasticity of the budget balance with respect to the output gap. I agree that fiscal multipliers are larger when we are at the zero interest lower bound, but I don't see how this can help us to explain a higher semi-elasticity.

  2. Answer to JP Santos:

    I agree the increase in AD might not be shared equally across the EMU members. It is still true that we have to fill the overall EMU gap.

    Regarding the effects of the zero interest lower bound on the semi-elasticity. The semi-elasticity can be decomposed into 2 parts:
    1. an elasticity of tax proceeds with respect to the relevant tax base. 2. an elasticity of the tax base relative to a cyclical indicator.
    The first is mainly determined by the tax system. The second however is estimated econometrically. For example the short term elasticity of unemployment with respect to the output gap is found by running the log difference of the unemployment gap on the log difference of the output gap. My concern was on the stability of this estimate, considering the special circumstances the economy experienced.

  3. Very interesting article, highlighting some points that seem clear ex-post but are not that obvious before thinking about them (the super-preverse effects of fiscal cuts in a liquidity trap flat LM situation).