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Deficits, public debt dynamics, and tax and spending multipliers

  • Matthew Denes
  • Gauti B. Eggertsson
  • Sophia Gilbukh

Cutting government spending on goods and services increases the budget deficit if the nominal interest rate is close to zero. This is the message of a simple but standard New Keynesian DSGE model calibrated with Bayesian methods. The cut in spending reduces output and thus—holding rates for labor and sales taxes constant—reduces revenues by even more than what is saved by the spending cut. Similarly, increasing sales taxes can increase the budget deficit rather than reduce it. Both results suggest limitations of “austerity measures” in low interest rate economies to cut budget deficits. Running budget deficits can by itself be either expansionary or contractionary for output, depending on how deficits interact with expectations about the long run in the model. If deficits trigger expectations of i) lower long-run government spending, ii) higher long-run sales taxes, or iii) higher future inflation, they are expansionary. If deficits trigger expectations of higher long-run labor taxes or lower long-run productivity, they are contractionary.

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Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 551.

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Date of creation: 2012
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Handle: RePEc:fip:fednsr:551
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  1. Isabel Horta Correia & Emmanuel Farhi & Juan Pablo Nicolini & Pedro Teles, 2011. "Unconventional Fiscal Policy at the Zero Bound," Working Papers w201103, Banco de Portugal, Economics and Research Department.
  2. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
  3. Davig, Troy & Leeper, Eric M., 2011. "Monetary-fiscal policy interactions and fiscal stimulus," European Economic Review, Elsevier, vol. 55(2), pages 211-227, February.
  4. Lawrence Christiano & Martin Eichenbaum & Sergio Rebelo, 2009. "When is the government spending multiplier large?," NBER Working Papers 15394, National Bureau of Economic Research, Inc.
  5. Todd B. Walker & Nora Traum & Eric M. Leeper, 2011. "The Fiscal Multiplier Morass: A Bayesian Perspective," 2011 Meeting Papers 583, Society for Economic Dynamics.
  6. Mertens, Karel & Ravn, Morten O, 2010. "Fiscal Policy in an Expectations Driven Liquidity Trap," CEPR Discussion Papers 7931, C.E.P.R. Discussion Papers.
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