THE ‘EXPANSIONARY FISCAL CONTRACTION’ HYPOTHESIS: A NEO-KEYNESIAN ANALYSIS

It has recently been argued that several fiscal contractions can, through their impact on expectations, lead to growth in consumption, investment and employment. Since such contractions typically occur because adjustment has been delayed due to fear of aggravating unemployment, we examine the hypothesis in a model with wage/price rigidities. The New Classical features of the model, however, allow expectational effects to be taken fully into account. While consumption and investment may rise, we find that employment is in all cases likely to fall; this leads us to believe that the so-called `German view' is overoptimistic.