This chapter examines the effects of fiscal consolidation —tax hikes and government spending cuts—on economic activity. Based on a historical analysis of fiscal consolidation in advanced economies, and on simulations of the IMF’s Global Integrated Monetary and Fiscal Model (GIMF), it finds that fiscal consolidation typically reduces output and raises unemployment in the short term. At the same time, interest rate cuts, a fall in the value of the currency, and a rise in net exports usually soften the contractionary impact. Consolidation is more painful when it relies primarily on tax hikes; this occurs largely because central banks typically provide less monetary stimulus during such episodes, particularly when they involve indirect tax hikes that raise inflation. Also, fiscal consolidation is more costly when the perceived risk of sovereign default is low. These findings suggest that budget deficit cuts are likely to be more painful if they occur simultaneously across many countries, and if monetary policy is not in a position to offset them. Over the long term, reducing government debt is likely to raise output, as real interest rates decline and the lighter burden of interest payments permits cuts to distortionary taxes. Budget deficits and government debt soared during the Great Recession. In 2009, the budget deficit averaged about 9 percent of GDP in advanced economies, up from only 1 percent of GDP in 2007. 1 By the end of 2010, government debt is expected to reach about 100 percent of GDP—its highest level in 50 years. Looking ahead, population aging could create even more serious problems for public finances. In response to these worrisome developments, virtually all advanced economies will face the challenge of fiscal consolidation. Indeed, many governments are already undertaking or planning The main authors of this chapter are Daniel Leigh (team

World growth in recent years has been much more rapid than at any time since the oil price surges of the 1970s. This growth is being shared across countries to an unprecedented degree. Moreover, output volatility in most countries and regions has significantly declined. This chapter analyzes these changes in business cycle characteristics and finds that the increasing stability and the associated increase in the durability of expansions largely reflect sources that are likely to prove persistent. In particular, improvements in the conduct of monetary and fiscal policy, as well as in broader institutional quality, have all reduced output volatility. The prospects for future stability should, however, not be taken for granted. Low average volatility does not mean that the business cycle is

market economies has remained remarkably subdued over the past two years despite a significant rise in commodity prices, strong growth, and a broadly accommodating monetary policy stance in the major currency areas. Is this situation sustainable or does it foreshadow unwelcome inflation surprises in the near future? Some analysts have argued that low and stable inflation reflects more intense global competition, which prevents firms from raising prices and puts downward pressures on wages in many sectors. 1 If so, and given that lower-cost producers in emerging markets and developing countries will continue to integrate into the global trading system, these