Reference no: EM133084000

In 2012, the International Monetary Fund suggested in its October World Economic Outlook that it may have underestimated the impact of deficit cuts on economic growth. In countries undergoing fiscal contractions, especially those in Europe at the time, this is important. The report then discussed the problem of debt sustainability, and later noted that in the 1980s the fiscal multipliers from global economic models were estimated to be between 0.4 and 3.5. During the next three decades the fiscal multiplier had fallen to be between 0.2 and 1.5, depending on the model.

a) Briefly explain how the size of the multiplier may affect a government's debt sustainability.

The reason for the wide range of estimates of the multiplier comes down to the assumptions about the way consumers, corporations and other government policies respond.

b) Briefly describe how the monetary policy response to fiscal policy is likely to affect the multiplier. How does your analysis change if you assume a fixed exchange rate instead of a flexible exchange rate?

c) Explain how the credibility of fiscal cuts likely matters, e.g. how it affects the performance of the economy as well as debt sustainability.