Effects of Fiscal Consolidat **i** on n the OECD In the MSG2 model private investment is partly determined by Tobin<sup>t</sup> s Q and partly by current fim profitability. Lower real interest rates raise Tobin's Q but also increase the cash flow of firms and this is an important determinant of the changes in investment in the model. The interest rates reduction from deficit reduction acts both through the cost of capital channels as well as through the liquidity constraint chlnnel.

The final important channel for the positive effects of a unilateral change in fiscal policy is via the exchange rate. As interest rates fall, the exchange rate of the country undergoing the fiscal consolidation depreciates in response to the outflow of private capital. The evidence on the links between interest rates and exchange rates is also mixed. In a recent study, Bosworth (1993) surveys the literature on this link and presents empirical support for this link as well as the link between exchange rate changes and changes in net exports.

## **_Evidencefrom_** _Large Scale_ **_Models_**

The results from the MSG2 model have been analyzed in depth. Results from other multicountry models tend to support the results presented above in the following sense. In Bryant et al (1986) a number of models performed standardized simulations of a fiscal expansion which was permanent and unanticipated. In that study, the fiscal expansion uniformly raised real GDP in the country undergoing the fiscal stimulus and also raised GDP in foreign economies. The fiscal expansion also increased interest rates in all models. In a more recent model comparison project summarized in Bryanr and McKibbin (1994), the positive fiscal multiplier is again found across all models although the size of the multiplier is lower than in the earlier model comparisons, primarily because of greater changes in real interest rates and exchange rates in the models compared in the updated study.

The issue of the impact of phased-in fiscal contractions is less clear. In models such as Project Link, DRI, GEM' etc, even a phased in fiscal contraction is contractionary for output. However these models have limited role for changes in asset prices and/or do not have forward looldng asset prices. The other multi-country model that has extensively analyzed phased in fiscal contractions is the MULTIMOD model at the IMF. In a recent study of the Clinton progrmm the results have been similar to those for the MSG2 model. In Clark and Symansky (1993) for example, the Clinton budget program raises GDP in 1993, reduces GDP in the years from 1994 through 1997 but then lead to GDP above baseline from 1998. It should be noted that the initial raise in GDP is due to a small fiscal stimulus that was included in ihe orginally proposed budget. When only a phased -in fiscal contraction is considered, GDP falls for a number of years being rising in the long run. In MULTIMOD, a rise in private investment and net exports both significantly dampen the fall in GDP. The mechanism is the same as that found in the MSG2 model. The fiscal contraction in the U.S. does not lower real GDP of industrial economies but does initially lower real GDP of developing countries in that study.

# 5. Condlusion

This paper has presented results for the impact of fiscal consolidation in the United States and Europe. It is shown that a credible reduction of fiscal deficits that is phased-in need not reduce aggregate demand in the short term. Over time as spending is cut or taxes raised, there is a negaive

> ' See **Allen** and Vines (1993) for results from the GEM model.

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