If indirect responses of private consumption and private investment overwhelm a direct
negative e¤ect of …scal consolidation, the economy becomes expansionary in spite of …scal
consolidation. This favorable e¤ect is labelled as a "non-Keynesian e¤ect" in some papers
because it contrasts with the traditional Keynesian view. Benk and Jakab (2012) present
some channels to explain possible non-Keynesian e¤ects. Among them, the mechanisms
1 3 8
Four scenarios of the …scal rule are as follows: (i) four items such as government spending, lump-sum transfers, capital income tax, and labour income tax respond to debt (ii) only capital and labour income taxes respond (iii) only lump-sum transfers respond (iv) only government spending responds.
which are related to this chapter are expectation channel, risk premium channel, and
consumption substitution e¤ects.
4.2.4.1. Expectation channel
Since the present …scal consolidation reduces the probability of a future …scal contraction,
households increase their consumption (Benk and Jakab, 2012). However, this expectation
e¤ect is limited under a marked fraction of non-Ricardian households139. Many previous
research departs from standard neoclassical models and adopts non-Ricardian households
(Coenen and Straub, 2005; Gali et al., 2007; Furceri and Mourougane, 2010; Erceg and
Linde, 2010; Coenen et al., 2013).140 An increase in the share of non-Ricardian households
raises the negative impact of …scal consolidation on output. For example, Erceg and Linde
(2010) …nd that the negative impact of a coordinated cut in government expenditures is
larger when the ratio of non-Ricardian households is higher. We follow the assumption of
the two types of households in the model.
4.2.4.2. Endogenous risk premium of bonds
The fall in the debt ratio through …scal consolidation may reduce a risk default premium
of government bonds. A decrease in real interest rate associated with this e¤ect stimulates
private investment and increases output (Benk and Jakab, 2012). Many previous literature
has examined the e¤ects of …scal variables on the risk premium of government bonds,
but their results are mixed. However, some papers …nd signi…cant results. For example,
using U.S. data Laubach (2009) …nds that one percentage point increase in the de…cit to
1 3 9
Households who do not have any assets, and just consume their current labour income are called as various names: non-Ricardian households, rule-of-thumb households, hand-to-mouth households. On the other hand, households who have full access to capital markets are called as Ricardian or optimising households. We use Ricardian and non-Ricardian households throughout this chapter.
1 4 0Ricardian equivalence does not hold with the two types of households since non-Ricardian households
GDP ratio raises the risk premium by about 25 basis points, and one percentage point
increase in the debt ratio adds 3 to 4 basis points to the risk premium. Laubach (2010)
analyses cross-sectional relationships between …scal stance and the risk premium using
a panel of 10 euro area countries and …nds that the e¤ect of …scal position depends on
circumstances. Speci…cally, before 2008 a one percentage point increase in the surplus to
GDP ratio decreases the risk premium by at most 3 basis points, and the e¤ect of the
debt ratio is 0.3 basis points at most. However, during the recent …nancial crisis, the
e¤ect becomes larger signi…cantly. A one percentage point reduction in the surplus ratio
increases the risk premium by 20 basis points, and a percentage point increase in the debt
ratio increases it by 0.8 basis points. Schuknecht et al. (2010) also …nd that coe¢ cients
for the de…cit ratio are 3-4 times higher and for the debt ratio 7-8 times higher during the
recent …nancial crisis than earlier using the data of 15 EU countries.141
Previous work develops DSGE models with endogenous government bond yields to
examine the e¤ects of …scal policy. The real interest rate is allowed to increase with a rise
in the debt target in Coenen et al. (2008).142 Furceri and Mourougane (2010) develop
a closed economy DSGE model with endogenous government bonds yields. Speci…cally,
the risk premium re‡ects market expectations on public debt (or public de…cit) and it is
calibrated following Laubach (2009). Erceg and Linde (2010) also allow credit spreads to
depend inversely on the de…cit and the debt to examine a possibility of output expansion
by …scal consolidation. On the other hand, Almeida et al. (2013) simply model the risk
premium as a shock following an AR (1) process.
Following these approaches, we allow for the endogenous response of the risk premium.
1 4 1
Speci…cally, one percentage increase in the de…cit ratio raises the spread by 3.49 basis points before the crisis, but the e¤ect is 12.64 basis points during the crisis. Similarly, an increase in the debt ratio by one percentage point results in the risk premium by 1.25 basis points during the crisis, whereas the e¤ect is 0.16 basis points before the crisis.
1 4 2They use relatively a small coe¢ cient implying that a one percentage-point fall in the debt ratio leads
In order to capture marked increases of the risk premium in a number of euro area countries
during the recent …nancial crisis, we assume that the risk premium reacts to the future
path of the debt ratio. As a robustness test, we examine how the impact of various …scal
consolidation strategies on macroeconomic variables changes when the endogenous risk
premium is omitted.
4.2.4.3. Consumption substitution e¤ects
Bouakez and Rebei (2007) analyse the consequences of a complementary relationship be-
tween private consumption and public consumption on the response of economic variables
to a positive government spending shock. According to their results, lower values of the
elasticity of substitution tend to further increase private consumption. Speci…cally, when
the elasticity is set to 1, the government spending shock causes a larger crowding-out e¤ect
on private consumption. However, when the elasticity is 0.25, the complementarity e¤ect
dominates the negative wealth e¤ect and private consumption is crowded-in in spite of the
increase of government spending. If government consumption has a substitution e¤ect with
private consumption, a cut in government consumption may increase private consumption,
thus, output.
Some models have incorporated a substitutability between private and public consump-
tion. For example, Forni et al. (2010) also assume higher degree of substitutability between
private and public consumption. However, other literature …nds that the relationship be-
tween government consumption and private consumption may be complementary (Leeper
et al., 2009; Coenen et al., 2013). In this case, …scal consolidation through the cut in
government consumption further worsens the economic situation.143
1 4 3
Ni (1995) estimates substitutability between private consumption and government consumption and …nd that inconclusive result. Speci…cally, the estimates depend on the speci…cation of utility function and the measurement of interest rates.
In our model, government consumption is assumed to have a complementary relation-
ship with private consumption following Coenen et al. (2013). In addition, we test the
robustness of our results with di¤erent values of complementarity between private and
government consumption.