Expansionary Effects of Fiscal Consolidation: The Role of Expectations and Interest Rates In the Case of Denmark

Abstract

The Danish fiscal consolidation of the early 1980s has received much scholarly attention because it was followed by an expansion of demand and output. The expansion of private consumption so far has been attributed to the expectations of future lower tax burdens. This article analyzes the outcome from a different perspective, suggesting that the decline in interest rates and also some degree of substitutability between private and public consumption played a crucial role in boosting private consumption. It shows that much of the consumption puzzle found in previous studies vanishes once the interest rate is included as an explanatory variable. This result is important from an economic policy perspective because it relates the expansionary effect to a variable that, in contrast to expectations about future tax cuts, is directly observable and more closely linked to the actual policy stance.