The economic impact of fiscal austerity

The interaction with monetary policy has a key role in determining the effects of a consolidation: Central banks can offset some of the contractionary pressures by cutting policy interest rates and longer-term rates also typically decline, cushioning the impact on consumption and investment.
Yet, if interest rates are near their effective floor, the effects of fiscal consolidation are more costly in terms of lost output.
Focusing on the effects of fiscal measures in interaction with monetary policy, Hall (2009) finds important differences in the multiplier depending on whether the economy is at a zero nominal interest rate, rising from under one in normal times to 1.7 at a zero lower bound. Christiano, Eichenbaum and Rebelo (2011) obtain an even stronger effect using the theoretical framework of Altig et al. (2010) and point out the significantly positive correlation between zero lower bound and multiplier's magnitude. Christiano et al. (2011) have demonstrated that the spending multiplier is likely to be larger if fiscal authorities schedule the spending to coincide with the period in which monetary policy is constrained by the zero lower bound.
Partly consistent with these results, Erceg and Lindé (2014) show that - if the liquidity trap is very persistent - the spending multiplier can be much larger than in normal circumstances, and so a given-sized government-spending hike can stimulate a much larger response of tax revenues than in normal times. In this situation, the multiplier can be so high that the expenditure is self-financing. Government debt falls for several quarters (lower right panel), a sharp contrast from the progressive rise in debt that occurs in normal times. These debt dynamics largely reflect that labor income tax revenue, and hence the primary balance, varies sharply with the spending multiplier. However, the government-spending multiplier declines sharply as spending increases and so larger spending programs may suffer from abruptly diminishing returns, and hence increase government debt at the margin. This is because the multiplier varies positively with the duration of the liquidity trap, and that the latter shortens as the level of spending rises.