DP7649 Debt consolidation and fiscal stabilization of deep recessions
The global financial crisis of 2008-09 has sent public debt on sharply higher trajectories. With the economic recovery gradually taking hold, the focus is now shifting to fiscal "exit" strategies. Medium-term consolidation efforts are likely to include not only tax increases but also sizeable spending cuts. Our paper uses a standard new Keynesian model to show that the anticipation of such medium-term spending cuts generally enhances the expansionary effect of short-run fiscal stimulus. This conclusion still applies when monetary policy is constrained by the zero lower bound on policy rates. In this case, however, the reversal of government spending must not occur too early on the recovery path, or at least must be suitably gradual.