Fiscal consolidation in an open economy with sovereign premia

We welfare rank various tax-spending-debt policies in a New Keynesian model of a small open econo- my featuring sovereign premia and loss of monetary policy independence. When we compute optimized state-contingent policy rules, our results are: (a) Debt consolidation comes at a short-term pain but the medium- and long-term gains can be substantial. (b) In the early phase of pain, the best Oscal policy mix is to cut public consumption spending and raise consumption tax rates to address the public debt problem, while, at the same time, cut capital tax rates to mitigate the recessionary e§ects of debt consolidation. (c) In the long run, the best way of using the Oscal space created is to reduce capital and labor taxes; the anticipation of such reductions plays a key role in the recovery from Oscal consolidation. (d) The Oscal authorities should also care about the output gap.