Investment and output effects of fiscal consolidations in a new-Keynesian DSGE model for the Euro Area: composition matters?

High current levels of deficit-to-GDP and debt-to-GDP ratios combined with medium- and long-term spending pressures on public finances urge the need for fiscal consolidations in most of the world. The literature on the short-term output effects of fiscal consolidations has been far from consensual, not only because theoretical predictions are somehow fragile, but also because empirical evidence is, at best, contradictory. In this context, this paper develops a new-Keynesian DSGE model, that includes a further detailed fiscal policy block than is usual in the literature, in order to analyse and understand the dynamic processes involved in the transmission of different fiscal consolidations, thus solving possible limitations of the empirical and historical studies. This paper follows a recent new generation of new-Keynesian general equilibrium models that include a more developed fiscal policy block (Coenen and Straub, 2005 ; Gali et al., 2007 ; Coenen et al., 2008 ). Within this model, that represents a closed economy with identical infinitely lived households, firms, a government and a monetary policy authority, we simulate several policy experiments of fiscal consolidations in which a fiscal policy shock occurs in isolation from other types of shocks to macroeconomic variables. In the fiscal policy block, while most of the literature treats government spending as consisting entirely of unproductive expenditure on goods,in this paper we consider three types of productive public expenditures: (i) highly productive spending; (ii) weakly or non- productive spending; and (iii) weakly or highly productive public employment. This allows us to evaluate the relative contribution of different public budget components, i.e., different compositions of the fiscal adjustment. The main findings are: (i) The success -- dimension and sustainability -- of fiscal consolidations, either via public spending reductions or employment costs reduction, decreases with the degree of their productivity; (ii) Consolidations through pure contractions of weakly-productive or, alternatively, non-productive public spending, generate short-run contractions of output; however, the effects on investment are opposite in these alternative routes for consolidation and, as a result, investment crowds-out and output falls twice as much in the case of weakly-productive spending consolidations as it does in the case of unproductive spending consolidations; (iii) If the consolidation is conducted simultaneously with a structural change in the fiscal budget in favor of more productive spending -- a cut in weakly (or non) productive spending together with a symmetric increase in highly-productive spending -- then our model predicts the existence of a positive short-run impact on output; (iv) Consolidation through a reduction in weakly-productive public employment yields results similar to those of a reduction in weakly-productive public spending; however the negative effects on output decrease with the degree of labor market competition and can even turn out to be positive in a perfect competition scenario.