Fiscal stimulus with spending reversals

Abstract

The short-run effects of fiscal policy depend not only on current tax and spending choices, but also on expectations about future policy adjustment. While general equilibrium models typically restrict mediumterm adjustment to taxation, we highlight the importance of government spending dynamics. First, we provide time series evidence for the United States suggesting that an exogenous increase in government spending prompts a rise in public debt, followed over time by a reduction in spending below trend. Second, we show how expected spending reversals alter the short-run impact of fiscal policy in a new Keynesian model, bringing it closer in line with the evidence.