Fiscal Consolidations: Can We Reap the Gain and Escape the Pain?

Under limited asset market participation fiscal consolidations have a deep and prolonged deflationary effect, causing substantial short term welfare losses to households whose access to financial markets is limited. We show that it is possible to both reduce public debt and boost consumption of constrained households. This is obtained by allowing taxes to immediately undershoot their post-consolidation steady-state values. A similar result is achieved if temporary public transfers to constrained households are exploited to stimulate demand. We also find that an interest rate rule which reacts not only to inflation but also to the output gap is an effective complement to fiscal policy as a stabilization tool. In fact, the output gap target induces the Central Bank to implement a stronger interest rate cut which triggers a surge in the consumption of Ricardian households. This in turn, has beneficial effects on labor incomes and on RT households' consumption. We obtain the apparently paradoxical result that such a policy allows to obtain better control of inflation, limiting deflationary pressures.