Debt targets and fiscal consolidation in a euro area HANK model

This paper develops a world economy HANK model for the Euro Area (EA) Core and Periphery, which captures key features of EA cross‐ and within‐country heterogeneity, to study debt target reforms. We show that fiscal consolidation under the current EA institutional arrangements is quite costly across and within countries, particularly affecting households in the Periphery. Reforming the EA debt targets closer to their historical values can significantly mitigate these welfare losses and make fiscal consolidation more affordable for households in the Periphery. Surprisingly, Core's fiscal expansion to facilitate Periphery's consolidation would not benefit most households in the Periphery, as it would reduce its household income and consumption due to decreased international competitiveness of periphery produced goods. Potential cross‐country fiscal externalities could increase the benefits of national fiscal reforms, especially for poor‐wealth households. Finally, we find that the welfare‐maximizing EA‐wide debt target lies between the member states' current debt‐to‐output ratios.