Can Severe Fiscal Contractions be Expansionary? Tales of Two Small European Countries
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
Only the empirical evidence can sort out which of these two contending views
about fiscal policy is more appropriate -- i.e how often the contractionary
effect of a fiscal consolidation prevails on its expansionary expectational
effect. This paper brings new evidence to bear on this issue drawing on. the
European exercise in fiscal rectitude of the 1980s, and focusing, in particulars
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 relevance.
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