Expansionary Contractions and Fiscal Free Lunches: Too Good to Be True?

Abstract

This paper builds a framework to jointly examine the possibilities of both expansionary fiscal contractions (austerity increasing output) and fiscal free lunches (expansions reducing government debt), arguments which in recent debates have been supported by the austerity and stimulus camps, respectively. We propose a new metric quantifying the budgetary implications of fiscal action, a key aspect of fiscal policy particularly at the monetary zero lower bound. We find that austerity needs to be highly persistent and credible in order to be expansionary, and stimulus needs to be temporary, responsive, and well‐targeted in order to lower debt. We conclude that neither is likely, especially during periods of economic distress.

Keywords: Austerity versus stimulus, fiscal policy, zero lower bound