To help us understand how the debates over austerity measures have evolved, this chapter reviews the more traditional literature on fiscal policy. Such analyses of fiscal policy might be divided into Keynesian and neoclassical approaches. Keynesian economics is typically associated with the view that expansionary fiscal policy raises overall output and employment; neoclassical approaches predict that that same fiscal policy will, at best, have fairly small positive effects on output and employment. Neither of these approaches suggests that there can be any circumstances in which a contractionary fiscal policy can be expansionary – such a view would seem bizarre to both Keynesian and neoclassical economists alike. In this chapter we will review the traditional approaches and consider evidence in their favour. In the next chapter the possibility that contractionary fiscal policy might be expansionary will be explored.

As far as theory is concerned, the Keynesian government expenditure multiplier is a useful starting point. Consider the national income condition for a closed economy:

This states that national income or GDP (Y) equals the sum of consumption (C), investment (I) and government spending on goods and services (G). It is better interpreted as an equilibrium condition rather than an identity. If there is a single good in the economy which can be used either for consumption, investment or purchased by the government, the equation tells us that the demand for the good equals the supply. The condition need not always hold as demand for output can differ from the supply if there are changes in inventories. If demand for output exceeds the supply then inventories of the good are being depleted; if supply exceeds the demand then inventories will accumulate. Such discrepancies cannot continue indefinitely. Inventories cannot be reduced indefinitely as they will eventually reach zero, although one would expect that firms would react to falling inventories by increasing output before that point is reached. If inventories are accumulating and are expected to continue doing so in the absence of a change in output, firms will have an incentive to reduce production, and in this way demand is brought back into equality with supply. In any case, equation (1) by itself does not tell us anything about what happens to output if government spending rises as it is possible that the other variables on the left-hand side change to offset a change in G, for example.