Effucis of Fiscal Conmolidaioan in the OECD First, refer to the results for the permanent reduction in government spending on goods and services in figure 3 and 4. The process of adjustment follows the familiar results of the theoretical Mundell-Fleming-Dombusch models. The reduction in government demand and the fall in government borrowing lead to a fall in interest rates in the United States (real and nominal, short and long). This leads to a capital outflow which depreciates the U.S. dollar by around 5.7 percent in effective terms. The large size of the U.S. economy in world capital markets and the movement of capital out of the United States, leads to a global fall in interest rates. The fall in U.S. domestic demand lowers world output in the first year but is more than offset by the stimulativ **e** ffects of lower world interest rates in subsequent periods.

The capital outflow is reflected in an improvement in the U.S. trade balance of around 0.6 percent of GDP in 1993. This improvement is gradually reversed over time. The subsequent deterioration (relative to baseline but not necessarily relative to 1993) reflects the intertemporal budget constraint: with a permanently smaller stock of external debt, the future U.S. trade surpluses that otherwise would be required to service the stock of external debt are now reduced. This is accomplished by a gradual appreciation of the U.S. dollar relative to baseline after the initial depreciation.

Inflation initially rises due to number of important factors. First, in the MSG2 model, consumer prices are used to measure inflation. Consumer prices include a rise in the price of imported goods reflecting the depreciation of the U.S. dollar. In addition some domestic goods require imported inputs into the production process. As the U.S. dollar depreciates, the cost of imported inputs rise. This leads to a rise in output prices.

The long terms positive effect on real GDP is driven by the assumption that, although forward looling, consumers are not completely Ricardian in this model. They discount future income streams at a higher rate than the real interest rate on government debt. Thus when government spending is reduced, to eliminate excess supply in the long run, interest rates fall which stimulates private investment in the long run. With higher investment, there is a higher capital stock and a higher capital output ratio. Thus the lower real interest rates are consistent with a lower marginal product of capital. With real wages adjusting to return the economy to fbil employment in the long run, the level of output will be higher due to the same quantity of labor inputs but a higher stock of physical capital.

Now compare the results under each of the three fiscal instruments. The income tax and the cut in government spending have similar consequences although there are a number of interesting differences. In terms of real GDP, the spending cut is more contractionary in the short run that the income tax increase but leads to a higher level of output in the long run than the income tax increase. This can also be interpreted in terms of the balance budget multiplier (adding a spending increase to a tax increase so that the deficit is unchanged). This multiplier is positive in the short term and negative in the long run. The long run result follows because consumers are not completely Ricardian in this model. Thus a change in government spending leads to a change in real interest rates in the long run, as described above. For a tax change in the long run, the fall in interest rates is smaller than the fall in interest rates under a spendiiig cut. The change in the marginal product of capital is also smaller under the inoome tax and therefore the capital stock rises by less under the income tax change. In the short term, the standard Keynesian multiplier is relevant. The spending cut reduces aggregate demand by more than an equivalent change in taxes which are partly financed by consumers by a reduction in saving. Thus private consumption does not fall by as much as public consumption and the decline in aggregate demand is smaller when taxes increase.

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