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IAI Actuarial Core Principles · Business Economics · Recent macroeconomic history

Critics of austerity after 2010 argued that simultaneous fiscal consolidation in many European economies could prove self-defeating for the debt-to-GDP ratio. Which argument best reflects this critique?

The critique is that spending cuts reduce output via a fiscal multiplier. GDP, the denominator of the debt ratio, then falls and tax revenues weaken, so debt-to-GDP may fail to improve or even rise, especially when many countries consolidate together and monetary policy has little room.

  1. ALower government spending raises private confidence so much that output always rises
  2. BCutting spending reduces GDP through a fiscal multiplier, so the denominator falls and debt ratios may not improve as expectedCorrect
  3. CAusterity increases tax revenue automatically through the Laffer effect at all tax rates
  4. DReducing deficits raises inflation, which erodes the real value of debt
  5. Austerity lowers the money supply, raising exchange rates and reducing imports

Explanation

If the fiscal multiplier is large, especially when interest rates are at the floor and many partners cut together, GDP falls by more than the saving and tax revenue weakens. Debt/GDP can then stay high or rise. Option A is the expansionary-austerity view, the opposite of the critique.

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