We examine global economic dynamics under learning in a New Keynesian model in which the interest-rate rule is subject to the zero lower bound. Under normal monetary and fiscal policy, the intended steady state is locally but not globally stable. Large pessimistic shocks to expectations can lead to deflationary spirals with falling prices and falling output. To avoid this outcome we recommend augmenting normal policies with aggressive monetary and fiscal policy that guarantee a lower bound on inflation. In contrast, policies geared toward ensuring an output lower bound are insufficient for avoiding deflationary spirals.

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

As discussed in Chapter 1, a global slowdown in activity, led by a sharp downturn in the United States and the spreading crisis in financial markets, will create more difficult external conditions for all regions of the world. This chapter examines in more detail how different regions are likely to fare in this environment and the policy challenges that are likely to arise. United States and Canada: How Long Will the Slowdown Last? The U.S. economy slowed markedly to grow 2.2 percent in 2007, down from almost 3 percent in 2006 (Table 2.1). The pace of activity weakened sharply in the fourth quarter to only 0.6 percent (at an annualized rate). With the housing correction continuing full blast, the contraction of residential investment sliced a full percentage point off growth in 2007. Consumption and business investment also softened markedly toward the end of the year, as sentiment soured and lending conditions tightened significantly after the outbreak of financial turbulence in August, despite the Federal Reserve’s aggressive turn to monetary easing. Rising oil prices helped dampen consumption, while also boosting 12-month headline inflation to 3.4 percent in February (measured using the personal consumption expenditure deflator). Core inflation has remained at about 2 percent, the top of the Federal Reserve’s implicit comfort zone. The one area of strength has been net exports, which have grown in response to the dollar’s sustained depreciation and the sluggishness of the U.S. economy relative to those of its trading partners. As a result, the current account deficit declined to less than 5 percent of GDP in the fourth quarter of 2007, Further analysis of trends and prospects in different regions is provided in the spring 2008 issues of Regional Economic Outlook. down 1 percent of GDP from the peak in 2006