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Can Severe Fiscal Contractions be Expansionary? Tales of Two Small European Countries

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  • Francesco Giavazzi
  • Marco Pagano

Abstract

According to conventional wisdom, a fiscal consolidation is likely to contract real aggregate demand. It has often been argued, however, that this conclusion is misleading as it neglects the role of expectations of future policy: if the fiscal consolidation is read by the private sector as a signal that the share of government spending in GDP is being permanently reduced, households will revise upwards their estimate of their permanent income, and will raise current and planned consumption. Only the empirical evidence can sort out which of these two contending views about fiscal policy is more appropriate -- i.e how often the contractionary effect of a fiscal consolidation prevails on its expansionary expectational effect. This paper brings new evidence to bear on this issue drawing on the European exercise in fiscal rectitude of the 1980s, and focusing, in particulars on its two most extreme cases -- Denmark and Ireland. We find that at least in the experience of these two countries the expectations' view has a serious claim to empirical relevance.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3372.

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Date of creation: May 1990
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Publication status: published as NBER Macroeconomic Annual 1990. Cambridge, MA: MIT Press.
Handle: RePEc:nbr:nberwo:3372

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  1. Francesco Giavazzi & Marco Pagano, 1989. "Confidence Crises and Public Debt Management," NBER Working Papers 2926, National Bureau of Economic Research, Inc.
  2. Barro, Robert J, 1979. "On the Determination of the Public Debt," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 87(5), pages 940-71, October.
  3. Blanchard, Olivier J, 1985. "Debt, Deficits, and Finite Horizons," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 93(2), pages 223-47, April.
  4. Jappelli, Tullio & Pagano, Marco, 1989. "Consumption and Capital Market Imperfections: An International Comparison," American Economic Review, American Economic Association, American Economic Association, vol. 79(5), pages 1088-1105, December.
  5. Barro, Robert J, 1981. "Output Effects of Government Purchases," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 89(6), pages 1086-1121, December.
  6. Alesina, A. & Drazen, A., 1991. "Why Are Stabilizations Delayed?," Papers, Tel Aviv - the Sackler Institute of Economic Studies 6-91, Tel Aviv - the Sackler Institute of Economic Studies.
  7. Hayashi, Fumio, 1982. "The Permanent Income Hypothesis: Estimation and Testing by Instrumental Variables," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 90(5), pages 895-916, October.
  8. Aschauer, David Alan, 1985. "Fiscal Policy and Aggregate Demand," American Economic Review, American Economic Association, American Economic Association, vol. 75(1), pages 117-27, March.
  9. Seater, John J. & Mariano, Roberto S., 1985. "New tests of the life cycle and tax discounting hypotheses," Journal of Monetary Economics, Elsevier, Elsevier, vol. 15(2), pages 195-215, March.
  10. Ahmed, Shaghil, 1987. "Government spending, the balance of trade and the terms of trade in British history," Journal of Monetary Economics, Elsevier, Elsevier, vol. 20(2), pages 195-220, September.
  11. Feldstein, Martin, 1982. "Government deficits and aggregate demand," Journal of Monetary Economics, Elsevier, Elsevier, vol. 9(1), pages 1-20.
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  1. Reforma laboral: Aquí y Ahora
    by Samuel Bentolila in Nada Es Gratis on 2010-03-10 22:05:42
  2. Can a reduction in government spending stimulate the economy?
    by Matt Mitchell in Neighborhood Effects on 2010-11-15 17:25:01
  3. The Impact of Spending Cuts on the Economy
    by Veronique de Rugy in The Corner on 2011-02-25 14:55:00
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