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The simple macroeconomics of fiscal austerity: Public debt, deficits and deficit caps

Thomas I. Palley

This paper explores the macroeconomics of fiscal austerity. A binding budget deficit cap makes the economy more volatile by turning the government budget into an automatic destabilizer. Public debt helps maintain aggregate demand (AD) in the presence of a lower price level because a lower price level increases the real value of public interest payments and also has a positive wealth effect. That makes public debt significantly different from private debt. If the economy is subject to a binding deficit cap public debt may no longer stabilize output. This is because increased real interest payments may be matched by spending cuts, giving rise to a negative balanced budget multiplier.

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