Working Paper: CEPR ID: DP9041
Authors: John F. Cogan; John B. Taylor; Volker Wieland; Maik H. Wolters
Abstract: In the aftermath of the global financial crisis and great recession, many countries face substantial deficits and growing debts. In the United States, federal government outlays as a ratio to GDP rose substantially from about 19.5 percent before the crisis to over 24 percent after the crisis. In this paper we consider a fiscal consolidation strategy that brings the budget to balance by gradually reducing this spending ratio over time to the level that prevailed prior to the crisis. A crucial issue is the impact of such a consolidation strategy on the economy. We use structural macroeconomic models to estimate this impact. We consider two types of dynamic stochastic general equilibrium models: a neoclassical growth model and more complicated models with price and wage rigidities and adjustment costs. We separate out the impact of reductions in government purchases and transfers, and we allow for a reduction in both distortionary taxes and government debt relative to the baseline of no consolidation. According to the initial model simulations GDP rises in the short run upon announcement and implementation of this fiscal consolidation strategy and remains higher than the baseline in the long run.
Keywords: budget deficit; fiscal consolidation strategy; fiscal policy; government debt; US budget
JEL Codes: E27; E62; H30; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Lower future government spending (H69) | Lower tax rates (H29) |
| Lower tax rates (H29) | Incentivizes employment (J68) |
| Lower tax rates (H29) | Stimulates economic activity (E20) |
| Anticipation of reduced government spending (E62) | Lower interest rates (E43) |
| Lower interest rates (E43) | Stimulates current demand (E47) |
| Lower interest rates (E43) | Mitigates short-term negative effects of spending cuts (E62) |
| Lower interest rates (E43) | Depreciation of exchange rate (F31) |
| Depreciation of exchange rate (F31) | Boosts net exports (F14) |
| Boosts net exports (F14) | Offsets declines in government spending (E62) |
| Fiscal consolidation strategy (E62) | GDP (E20) |