DP417 | Can Severe Fiscal Contractions Be Expansionary? Tales of Two Small European Countries

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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 distinguish which view is the more appropriate, that is, how often the contractionary effect of a fiscal consolidation prevails over its expansionary expectational effect. This paper presents new evidence, drawing on the European exercise in fiscal rectitude of the 1980s and focusing 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 relevan.