For example, tax increases at high levels of government indebtedness or a sustained reduction of government expenditures may lead to higher private wealth (Blanchard 1990, Sutherland 1997) and lower interest rates and improved business confidence.<sup>30</sup> In this case, consumption and investment may both rise (Giavazzi et al 2000). Empirical work has uncovered some evidence of these effects. For example, Giavazzi and Pagano (1990), Alesina and Ardagna (1998) among others, find a positive relation between fiscal consolidation and output growth.<sup>31</sup> If fiscal consolidation is read by the private sector as a signal that the debt ratio will be permanently reduced, then their estimate of permanent disposable income rises and both temporary and permanent consumption should increase. The size of this wealth effect depends on whether households are liquidity constrained and on the _efficiency of the financial sector_ . For non‐Keynesian effects to dominate investment behavior, the credibility argument must apply so that the fall in risk premia is sufficiently large to raise demand. They also contend that the monetary stance (which may take the form of a small devaluation) is critical for the expansionary impact. While several studies have attempted to discover overall positive output effects of consolidation, the empirical evidence is not strong.

_<u>Disagreement on the size of the Keynesian multiplier.</u>_ The overall effects of fiscal consolidation depend on the size of the Keynesian multiplier. Recent papers estimating fiscal multipliers for the four countries find substantially varying magnitudes depending on the timeframe and method used. In a recent paper, Blanchard and Leigh (2013) conclude that fiscal multipliers had been underestimated in the IMF’s 2012 (WEO) projections in which they had assumed a multiplier of 0.5 on average for advanced economies. The actual values were in the range 0.9‐1.7 in the post‐financial recession period. Fatas and Summers (2016) find that the multipliers for the 2011 fiscal consolidations were 1.8 for Europe overall and 2 for the Euro members. EC research on the topic finds more modest multipliers between 0.5‐0.7 for a balanced composition adjustment, although they conclude that where the private sector is liquidity constrained, multipliers tend to be larger.

Revisiting the conditions under which output multipliers are larger is important to understanding the impact of consolidation on GIPS. Among recent papers, Ilzetski et al (2011), for a sample of 44 countries, find that the effect of changes in government consumption is small in the immediate run, but in economies with fixed exchange rates or those that are closed to trade, these multipliers are large over the long run. Baum et al (2012) find that fiscal multipliers vary according to the business cycle‐ being larger in downturns. Larger values dominate when countries are in recession, when monetary policy is constrained by the zero lower bound, when there is synchronized fiscal adjustment among a group of countries, and when there is substantial economic slack.<sup>32</sup> Christiano et al (2011) have shown that when the lower bound on the nominal interest rate is binding, multipliers can be as large as 3. Cugnasca and Rother (2015) find fiscal multipliers around 1.6 for 27 economies when the interest rate was at or near the lower bound. In addition, a poorly functioning financial system means that demand is more dependent on current income and multipliers are larger (Eggertsson and Krugman, 2012). Fatas and Summers (2016) also note that their estimate of the magnitude of multipliers would be boosted by the fact that the latest recession occurred with either monetary policy was at the zero lower bound or exchange rate policies were not available (Euro area countries). They discuss conditions under which fiscal consolidations are self‐ defeating, defining a “hysteresis parameter” or the degree to which potential output changes in relation to changes in temporary output falls. The larger the value of the fiscal multiplier and the tax rate, the larger will be the loss in permanent tax revenues, and the more likely that fiscal consolidations will be self‐defeating: they will increase the debt to GDP ratio. Aghion et al (2009) find that anti‐cyclical fiscal

> 30 Bertola and Drazen (1993) and Perotti (1999) provide a theoretical perspective while Briotti (2005) provides an overview.

> 31 Their analysis pertains to the short run effects of fiscal consolidation; they do not analyze the long run growth effects of fiscal policies.

> 32 Auerbach and Gorodnichenko, 2012; Batini et al, 2012; IMF, 2012b; Woodford, 2011.

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