Expansionary fiscal contraction: A theoretical exploration

This paper presents a dynamic general equilibrium analysis of the hypothesis that fiscal spending reductions may be expansionary. The impact of balanced budget fiscal spending on output in this model is normally negative. Quantitatively, these effects can be large. Moreover, the effects are distinctly non-linear; the higher is the initial fiscal spending to GDP ratio, the greater the expansionary impact of fiscal spending cuts. Nevertheless, the effects are likely to be accrued only gradually, so that fiscal contraction does not lead to large immediate increases in output. The analysis is extended to an economy with unemployment, and to an open economy. Some discussion of the empirical relevance of the hypothesis is presented. (C) 2003 Elsevier Science Inc. All rights reserved.