Austerity Programs under Liquidity Constraints: Stylized Facts of Recession in the Euro Area

Employing a stochastic Brownian pattern for labor income under liquidity constraints, the paper derives closed-form solutions for households’ consumption and shows how both the multiplier and the variability of consumption increased after the global crisis and were further enhanced by the austerity programs. The properties of the theoretical model are found to be in line with a number of stylized facts observed in the Southern Euro Area countries, where recession is ravaging for three years after the implementation of austerity programs. A critical factor of such a prolonged recession was that austerity programs were at the same time too harsh and intensive, grossly underestimating the adverse effects on economic activity. The paper argues that the same fiscal adjustment could have been achieved more gradually and with milder effects on households’ demand.