Optimal Fiscal Consolidation Under Frictional Financial Markets*

This paper studies optimal fiscal policy in a currency union subject to capital flow shocks in an economy with two main ingredients: (i) sticky prices and (ii) financially constrained arbitrageurs. Given capital outflows and high external debt, the fiscal authority faces a trade-off between stimulating the economy or paying off external debt. The planner reduces the value-added tax in the short run, while it raises and front-loads the sum of value-added tax and payroll taxes. It is not optimal to use spending to stimulate the economy. The country engages in a fiscal consolidation, as government debt falls compared with a passive fiscal policy.