Therefore, the negative effect of the fiscal contraction on output is larger than the positive effect of the fiscal expansion. In a more sophisticated model of a dynamic economy, a fiscal contraction at the effective lower bound can be shown to do even more harm by reducing inflation expectations and raising the real interest rate. This further depresses private spending and inflation.
Ok, let’s pause here for a moment. I realize that for some of you, this was all a bit intense. Sometimes, the economics professor in me gets the upper hand. Yet it’s useful to grasp some basic theory, in order to appreciate what happened in the euro area over the past ten years and to understand the policy challenges that lie ahead of us.