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Expansionary Fiscal Contractions: Re-evaluating the Danish Case

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  • U. Michael Bergman
  • Michael Hutchison

Abstract

The Expansionary Fiscal Contraction (EFC) hypothesis predicts that a major fiscal consolidation leads to an economic expansion under certain circumstances. We test this hypothesis, and the implied non-linear responses of the economy to large and small changes in fiscal policy, using data from the 1983 Danish fiscal reform. We use a structural VAR/event study methodology following Blanchard and Perotti (2002) that explicitly allows us to distinguish between normally marginal changes in fiscal policy and comprehensive fiscal reforms. We find that 'marginal changes' in fiscal policy (expenditure and tax changes) have the expected Keynesian effects on output and consumption. However, we find no evidence that the large fiscal consolidation in Denmark slowed the economy after controlling for a host of exogenous shocks and business cycle effects. Rather, we find some support for the hypothesis that the exogenous fiscal contraction in Denmark was a credible regime shift and, together with other reforms undertaken at the time, increased both private consumption and aggregate output.

Suggested Citation

  • U. Michael Bergman & Michael Hutchison, 2010. "Expansionary Fiscal Contractions: Re-evaluating the Danish Case," International Economic Journal, Taylor & Francis Journals, vol. 24(1), pages 71-93.
    • Handle: RePEc:taf:intecj:v:24:y:2010:i:1:p:71-93
    DOI: 10.1080/10168731003589857
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    1. Höppner, Florian & Wesche, Katrin, 2000. "Non-linear Effects of Fiscal Policy in Germany: A Markov-Switching Approach," Bonn Econ Discussion Papers 9/2000, University of Bonn, Bonn Graduate School of Economics (BGSE).
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    4. Ms. Selma Mahfouz & Mr. Richard Hemming & Mr. Michael Kell, 2002. "The Effectiveness of Fiscal Policy in Stimulating Economic Activity: A Review of the Literature," IMF Working Papers 2002/208, International Monetary Fund.
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