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Q5 Explain why, and how, a country's public debt, if it exceeds a certain threshold level, might lead to a contractionary budget having a stimulating effect on aggregate demand (expansionary fiscal contraction).

The core of the problem, here, is to understand the role of expectations on future policy actions and interest rates. Since a high public debt is regarded as dangerous for the economy (because it is a source of instability, inflation, high interest rates and high taxes), policies aimed to reduce it through fiscal contraction give encouragement to economic agents and financial markets. If a government of a highly indebted country makes a firm commitment to reduce its debt and, if the government is stable and credible, the contractionary policy is seen as a guarantee of price and financial stability. The premium will be a declining long-term interest rate due to the lower risk.

This reduction has positive effects both on investment (lower cost of borrowing money) and on consumption (particularly of durable goods). Furthermore, the lower interest rate helps the government in reducing the cost of debt allowing either a cut in taxes or giving room to an expansion of primary balance. These expansionary effects might outweigh the traditional negative short-term impulse derived from fiscal restriction, thus creating a sort of 'crowding in' effect. Contraction through spending cuts is more effective than through increase in taxes: high taxes worsen competitiveness and can give to the markets a signal of postponed adjustment.

There is some empirical evidence of this expansionary fiscal contraction in EU countries, transition economies and developing countries, particularly in countries where the debt is so high that is considered unsustainable by financial markets (the positive effect on interest rates of the Italian budget policy in 1997 is an example).


Q1 Assume the following situation occurred in an economy:

Unemployment rises and output falls dramatically, consumption and investment declines and prices actually fall. Furthermore, the stock market crashes.

Propose remedies for this situation.

This situation, resembling the great depression of 1929, is mainly due to a self-reinforcing crisis of confidence and pessimistic expectations over the future.  Such a situation could worsen if the economic authorities responded proposing fiscal balance. Balanced budget is not, in all circumstances, a sign of good economic management.  In this situation, the government ought to use a mix of expansionary fiscal and monetary policies:

i) The government should expand fiscal policy through public consumption and investment. These policies would support aggregate demand, replacing private expenditure and sustaining employment and income.

ii) The central bank should avoid restricting money supply.  Deflation can be as dangerous as inflation in some cases (see Chapter 12, pp. 306-307).  Falling prices have deteriorating effects on consumption (consumers wait to purchase


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