Recently, as Congress considers policies to foster economic growth, arguments have been made that some traditional expectations of fiscal policy should be revisited, namely that cutting spending will contract the economy in the short run. Under this view, what would normally be considered contractionary fiscal policy would instead be expansionary. Proponents of this view also argue that cutting spending rather than raising taxes would be a more effective means of increasing economic growth. These arguments often refer to recent empirical studies of deficit reductions across countries. This view contrasts with that held by most economists, which will be referred to as "mainstream economics." Mainstream economics relies on a basic theory regarding policies to expand the economy in a downturn. This theory can be found in economics textbooks and is used by government and private forecasters to project the path of the economy. This view has been the basis for fiscal and monetary policy interventions to stimulate the economy for many years, under both Republican and Democratic administrations. Chairman Bernanke of the Federal Reserve was referring to this view when he cautioned against large and immediate spending cuts. The basic thrust of the model for fiscal policy is that increasing the deficit (whether by increasing spending or cutting taxes) expands an underemployed economy, and decreasing the deficit (cutting spending or raising taxes) contracts it. Just as economists generally consider spending cuts to be contractionary in the short run in an underemployed economy, they believe that deficits can be harmful in the long run by crowding out private investment. There is widespread agreement that the continuation of current tax and spending policies will lead to an unsustainable path of the national debt. The fundamental cause of these long-run problems predates the Great Recession and the increase in debt relative to GDP from that recession, and arises from the aging of the population and the growth in health care costs. Thus, to most economists, the policy challenge is a trade-off between the benefits of starting to address the debt problem earlier versus risking damage to a still-fragile economy by engaging in contractionary fiscal policy, or failure to continue with expansionary fiscal policy. Although the unemployment rate has been falling, it remains high, and the growth rate, while strong in the third quarter of 2012 (3.1%), was 1.3% in the second quarter of 2012. This report begins with an overview of this mainstream theory. The next section of the report then examines the evidence that has been used to challenge this theory. Current fiscal policy theories began with a work published during the Great Depression by British economist John Maynard Keynes. As a result, this type of policy is often referred to as Keynesian, although there have been numerous refinements and developments in the theory. These developments include, among others, the standard model (referred to as IS-LM ) that includes both monetary and fiscal policy, the refinement of the tradeoff between inflation and unemployment, leading to the notion of a natural rate of unemployment (where policies tend to affect price rather than output), the incorporation of expectations, and modifications for an open economy (where goods and capital flow across borders). Some commentators contrast Keynesian economics with neoclassical economics. Neoclassical economics originated in the late 19 th century and theorizes that output and prices adjust to forces of supply and demand. Supply and demand are, in turn, driven by decisions made by economic agents (consumers, workers, and producers) who maximize their welfare. Most economists have both neoclassical and Keynesian-style views, one applied largely to questions of microeconomics and the other to questions of macroeconomics. Since World War II, government policy to address business cycles has generally been guided by some form of Keynesian theory. The fundamental concept behind this view of macroeconomics and fiscal policy is that prices in an economy do not immediately adjust to shocks, which can lead to unemployment of resources. Workers may become unemployed and capital may sit idle, due to a lack of sufficient demand. To reduce unemployment, expansionary fiscal policy (an increase in spending or a reduction in taxes to expand aggregate demand) can be employed. The magnitude of the effects of fiscal policy is measured by a multiplier. If the government spends a dollar, then someone in the economy receives a dollar. Part of that dollar might be saved and part might be spent; to the extent that it is spent, it increases aggregate demand in a second round. The recipients of that second round of spending will in turn spend part of their receipts. There are multiple rounds of spending, each diminishing a bit because part is saved, and the sum of all these rounds defines the multiplier. As demand increases, businesses hire additional workers and purchase more capital goods to satisfy demand. The strength of the multiplier depends not only on the share that is spent in the initial and subsequent rounds but also on the effect on interest rates and prices. As demand increases it places upward pressure on interest rates, reducing private sector spending on investment and consumer durables, and also, in an open economy, attracting capital flows into the United States, appreciating currency, and reducing net exports. When the economy is at full employment or close to full employment, the effects of a stimulus are more likely to lead to price increases rather than real output growth. In this case, the deficit spending crowds out investment and net exports. Thus, even for a particular type of spending or tax cut its short run effects are likely smaller at higher interest rates, smaller for small open economies with a large trade sector and flexible exchange rates, and smaller for economies at or close to full employment. Under current circumstances, there is little indication that deficits have significantly crowded out investment or exports, since interest rates have remained extremely low. They are also not likely to have led to price increases given significant unemployment in the U.S. economy and low inflation rates. The estimated size of the fiscal multiplier also depends on assumptions about monetary policy and its response to a fiscal stimulus. One might think of a neutral monetary response as one that permits the fiscal stimulus to increase interest rates, output, and prices (in the context of the IS-LM model, equivalent to keeping money supply fixed). The monetary authorities may, at one extreme, keep the interest rate fixed, which will enhance the fiscal stimulus, or, at the other, keep prices fixed, which will offset the fiscal stimulus. In the recent recession, both interest rates and inflation remain low. In a fully employed economy, fiscal stimulus will not affect output, but rather the composition of output. Without an offsetting change in the nominal money supply, prices will rise to reduce the real value of money. Alternatively, the money supply can be contracted to be consistent with total output without a price increase. As indicated in Figure 1 , which plots growth rates since 1821, the post-World War II period has been characterized by much more moderate business cycles (to the right of the vertical line), and limited instances of negative growth, as compared to those occurring in the latter half of the 19 th century and the first half of the 20 th century. (Note, however, that data for earlier years is less reliable.) Moreover, it is generally agreed one of the more significant contractions, in the early 1980s, was deliberately brought about by restrictive monetary policy (which may, however, have been more restrictive than initially planned). Along with the practice of countercyclical monetary and fiscal policy (or at least an understanding of what policies could make things worse, as they had in the past), business cycles may have been moderated by deposit insurance, automatic stabilizers (transfer and tax systems that automatically increase the deficit during downturns), and the expectation that the government will counter business cycles, which may help to reduce panics in the first place, though some believe they may also increase the risk of speculative bubbles. Some debates have centered on whether fiscal or monetary policy (or both) should be used as tools of discretionary policy. Both are susceptible to policy lags. Some economists came to believe that political lags made fiscal policy ill-timed, while monetary policy could be enacted quickly. Others became less enamored of fiscal policy because it becomes somewhat less effective in an open economy. At the same time, there are circumstances where traditional monetary policy does not work well (at very low interest rates, for example) or where a contraction appears to be serious enough to warrant both monetary and fiscal measures. During the 2007–2009 Great Recession there was broad bipartisan agreement that fiscal stimulus should be used, as it was in both the Bush and Obama Administrations. The textbook consensus is that spending increases are more effective than tax cuts, because the full amount of the initial increase is actually spent, while some of a tax cut is initially saved. Spending in the form of transfers could also be partially saved, although it is believed that most transfers benefit lower-income recipients who are likely to spend all or most of the transfer. Different types of tax or spending policies may also have different effects depending on the portion initially saved. At the same time, much federal government spending is funneled through the states and a portion of spending in the form of grants to states could also be saved. The spending funneled through the states could include both government purchases of goods and services or transfers. Table 1 shows a list of multipliers provided by a major private forecaster during mid-2008. It illustrates the different multipliers embedded in his forecasting model. Consistent with the theory above, the spending multipliers in this model are larger than tax cut multipliers. Among tax cuts, those that are likely to go to middle- and lower-income individuals (notably a refundable tax credit) have larger effects than those going to higher-income taxpayers (such as the alternative minimum tax or taxes on dividends or capital gains). This difference reflects different propensities to save: higher-income individuals tend to save more and cutting their taxes increases demand less per dollar of tax cut.