Fiscal Retrenchments and the Level of Economic Activity

Working Paper 99-3
by Giovanni Olivei
1999 Series

I analyze the effects of an expected future reduction in government spending on the current level of economic activity. In a closed-economy dynamic general equilibrium setup with nominal rigidities, it is shown that expected future cuts in government spending generate an increase in current GDP. Nominal rigidities are an essential feature for the emergence of such a result. With perfectly flexible prices but in an otherwise identical setup, an expected future decline in government spending entails no increase in the current level of economic activity.

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