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The effects of fiscal consolidation in the OECD

Listed author(s):
  • McKibbin, Warwick J.

Despite the current recession in many parts of the OECD, fiscal consolidation is likely in many OECD economies in the 1990s. The author asks: is fiscal consolidation in the OECD in a period of low growth a recipe for global stagnation? In particular, what effects are likely in developing countries? The author starts with an overview of cuts in the U.S. fiscal deficit proposed by the Clinton administration and the extent to which European governments must cut fiscal deficits between now and 1997 to satisfy deficit targets in the Maastricht Treaty. How changes in fiscal policy are transmitted within an economy and between that economy and the rest of the world depends on whether those changes lead to permanent or temporary changes in government saving; whether they are implemented through government spending or taxes; and whether the taxes fall on households or firms. The main channels of transmission are through changes in: agents'expectations about future taxes, interest rates, exchange rates, and economic activity. The author uses the MSG2 multicountry models to quantify the ramifications of those changes. He concludes, among other things, that fiscal contraction in the OECD will probably lead to slower growth over the next several years. But the current and likely paths of fiscal policy are such that deficit reduction programs may have stimulating effect in the short run, as long as future fiscal contraction is credible. And fiscal deficit reduction will probably increase long-run output in the OECD through its effects on savings and investment. Finally, growth in the developing countries (at least total growth) may not be impaired at all by fiscal consolidationin the OECD. The negative effects of fiscal contraction will occur through lower net exports of non-OECD economies. For developing countries with open capital markets, the initial reduction in demand through lower exports can be offset by the reduction in interest rates following an inflow of capital from the countries with contracting fiscal policy. A significant decline in real global interest rates is likely to increase growth in developing countries that are debt-constrained, either directly (through private capital inflows) or indirectly (by relaxing the balance of payments constraint, allowing more resources to be channeled to domestic investment needs).

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Paper provided by The World Bank in its series Policy Research Working Paper Series with number 1354.

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Date of creation: 30 Sep 1994
Handle: RePEc:wbk:wbrwps:1354
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  1. B. Douglas Bernheim, 1987. "Ricardian Equivalence: An Evaluation of Theory and Evidence," NBER Chapters,in: NBER Macroeconomics Annual 1987, Volume 2, pages 263-316 National Bureau of Economic Research, Inc.
  2. Steven M. Fazzari & R. Glenn Hubbard & BRUCE C. PETERSEN, 1988. "Financing Constraints and Corporate Investment," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 19(1), pages 141-206.
  3. Seater, John J, 1993. "Ricardian Equivalence," Journal of Economic Literature, American Economic Association, vol. 31(1), pages 142-190, March.
  4. Hayashi, Fumio, 1982. "Tobin's Marginal q and Average q: A Neoclassical Interpretation," Econometrica, Econometric Society, vol. 50(1), pages 213-224, January.
  5. Evans, Paul, 1985. "Do Large Deficits Produce High Interest Rates?," American Economic Review, American Economic Association, vol. 75(1), pages 68-87, March.
  6. Jorgenson, Dale W, 1971. "Econometric Studies of Investment Behavior: A Survey," Journal of Economic Literature, American Economic Association, vol. 9(4), pages 1111-1147, December.
  7. Mckibbin, W.J. & Wilcoxen, P.J., 1992. "The Global Costs of Policies to Reduce Greenhouse Gas Emissions," Papers 97, Brookings Institution - Working Papers.
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