The GDP Impact a U.S. Fiscal Consolidation Strategy

Three and half years ago, in February 2009, John Cogan, Volker Wieland, Tobias Cwik and I estimated what the impact of the 2009 stimulus package (ARRA) would be. Our estimates, obtained by simulating modern macroeconomic models, were much smaller than those of the Administration. Since then our estimates have been verified in research by a group of economists at central banks and international financial institutions who found that our simulations were in mid-range of their models.

Now, Wieland, Cogan and I, joined by Maik Wolters, are simulating modern macroeconomic models to evaluate a fiscal consolidation strategy to reduce the deficit and end the explosion of the debt. We are using two models which incorporate forward looking behavior, one with price and wage rigidities and one with more classical features. We have examined a gradual, credible strategy to reduce federal spending as a share of GDP—relative to current policy as assumed in the CBO alternative fiscal scenario baseline and starting in the first quarter of 2013—as shown in this chart.

Our initial findings, reported here, are that this strategy has a positive impact of GDP, in both the short run and the long run. The positive short run economic effects occur even in the model with price and wage rigidities for several reasons including that the lower spending (as a share of GDP) can reduce expected tax rates and raise permanent after-tax income compared to what would be expected under current policy. This stimulates consumption. The gradual nature of the government spending reduction, which allows time for private spending to adjust, avoids the negative aggregate demand effects that traditional Keynesian models emphasize.