with Miguel Ferreira, Francesco Franco, Hans Holter and Laurence Malafry.
Abstract: Following the Great Recession, many European countries implemented fiscal consolidation policies, aimed at reducing government debt. In a recent paper, Blanchard and Leigh (2013) show that these policies had significant negative effects on output and argue that the effects were generally miscalculated by the IMF. Other than the size of the fiscal consolidation they can, however, not find any factor that helps reducing the forecast error. Using the same data, we document a strong positive empirical relationship between higher income inequality and stronger recessive impacts of austerity across European countries. To explain this finding, we develop a life-cycle, overlapping generations economy with uninsurable labor market risk. We calibrate our model to match key characteristics of a number of European economies, including the distribution of wages and wealth, social security, taxes and debt and study the effects of fiscal consolidation programs. We find that higher income risk induces precautionary savings behavior and decreases the proportion of credit-constrained agents in the economy. Credit constrained agents have a higher marginal propensity to consume goods and leisure and their labor supply respond less in response to increases in taxes or decreases in government expenditures. This explains the relation between income inequality and impact of fiscal consolidation programs. Our model produces a cross-country pattern between inequality and the fiscal multipliers, resulting from consolidation, which is quite similar to that in the data.
You can access the latest version of the working paper here.