Effects of Fiscal Consolidation in die OECD

# _c) Permanent Versus Temporaty Versus Andtipated Policies_

We now consider the different between the time path and permanencc of fiscal policy changes. -Again we use the fiscal contracdon in the U-S. as the example. We also focus on a reduction in spending on goods and services because the intuition on the effect of the time path of policy follows for each of the three alternative means of deficit reduction.

Figures 6 through 8 contain results for the permanent cut in govermment spending that we have already analyzed. In addition, we show results for a temporary cut in government spending which consists of a cut of 1.6 % of GDP in 1993 but spending returning to baseline from 1994 onwards. The third comparison is with a permanent cut in spending that is phased in from 1993 to 1996. This policy is a reduction of 0.4% of GDP in 1993, 0.8% of GDP in 1994, 1.2% of GDP in 1995 and 1.6% of GDP from 1996 forever. 4 The results for the United States are shown in figure 6. In the case where the spending cut is temporary, the initial fall in U.S. GDP is largest; close to 1.4% relative to 0.5% for the permanent policy. This result is because the real interest rate reduction is much smaller and the exchange rate depreciation is much smaller for a temporary change in government spending. In addition to the larger output effects, the consequences for trade are much smaller for the temporary policy. In the long run there is no effect of this policy.

In contrast, the results for an anticipated (or phased in) policy are also shown in Figure 6. A key point to note is the initial rise in U.S. real GDP as a result of the policy. This occurs because the spending cuts are primarily in the futr whereas the changes in asset prices stimulate demand in 1993. The fall in interest rate acts as a stimulus, partly through intertemporal channels, but also because it reduces liquidity constraints on a proportion of firms and households in the model. In addition, the depreciation of the real exchange rate stimulates net exports which raises aggregate demand. Eventually the phased-in policy and the permanent policy lead to the same outcomes.

Figure 8 presents results for the transmission of the three types of spending cuts to the rest of the world. As with the results inside the U.S. the transmission to other countries is quite different. The negative effects of the policy for foreign GDP is again largest for the temporary policy because there is little reduction in global real interest rates in this case. Note that when the policy is phased-in, the fall in interest rates in the rest of the world dominates any negative effects of the contraction in U.S. output from 1994 dtrough 1997 and GDP in the rest of the world is permanently above baseline. Thus although fiscal contraction reduces output at some point in the country undertaking the contraction, the timing of the cuts in fiscal deficits can be crucial for the sign of the transmission of this policy to other countries. This is an example where the changes in asset prices more than offset the negative Keynesian demand effects for each year.

Figure 8a shows the importance of the timing of spending cuts for the transmission of the policy to non-oil developing countries. The temporary policy leads to a larger trade balance deficit in the developing countries because of the smaller stimulus to exports. The trade balance actually improves for the anticipated policy because exports rise by less.

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