Fiscal Consolidation in a Low Inflation environment: Pay Cuts versus Lost Jobs

Guilherme de Almeida Bandeira | European University Institute

We construct a two-country model of a monetary union to study fiscal consolidation through cuts in public sector wages or hiring when the nominal interest rate is constrained at its lower bound. The low inflation environment increases debt-to-GDP levels, requiring more pronounced wage and hiring cuts to achieve a given consolidation. Comparing the two instruments, cuts in public hiring increase unemployment persistently in this environment, while wage cuts reduce unemployment. In particular, we show that the increase in unemployment after vacancy cuts is amplified when the public good is productivity- or utility-enhancing. Since public wage bill cuts induce the reallocation of workers from the public to the private sector, regions with higher labor mobility between the two sectors are better placed to reap the positive effects from consolidation. Consolidation in one block of the union amplifies the negative effects of the low inflation environment in that block, and we find it has more negative effects when that block is less open to trade or relatively smaller within the union.