The industrialized world suffered over the last few years a number of large negative shocks, initially driven by sharp declines in house and stock prices and by a tightening of credit and financial conditions. The collapse in output and the increase in unemployment produced a loss of confidence that considerably intensified the recessionary pressures. Policy institutions responded with measures that dealt with the solvency of financial institutions.
Central banks, on the other hand, reduced interest rates to unprecedented low levels to support aggregate demand and used non-conventional quantitative or credit easing measures to reduce risk premia and to provide liquidity to the financial sector. Despite all efforts, credit remained tight and aggregate demand weakened rapidly. There were important spillovers from industrialized economies to less developed ones increasing the concern that the world economy might be moving into a deep and prolonged recession.
Given that nominal interest rates approached or hit the zero lower bound and that the room for maneuvering credit was limited by the inability of the banking system to properly function, the scope for further monetary stimulus was limited and attention turned to fiscal policy. At the beginning of 2009, governments around the world announced major two years stimulus packages to sustain employment and growth. The packages were extraordinary in size (reaching up to 2 percent of national GDP) and in breath.
The U.S. Congress, for example, approved 787 billion dollars of additional spending, transfers and tax reductions with the 2009 American Recovery and Reinvestment Act; the European Union initiated the European Economic Recovery Plan, while national governments announced their own plans, see e.g. the ‘’ Pacchetto Fiscale’’ in Italy, the ‘’Plan E’’ in Spain, the ‘’Plan de Relance’’ in France, the ‘’Konjunkurpaket I &II’’ in Germany and the ‘’Pre Budget Report’’ in the UK. The legislation raised old questions concerning the effectiveness of temporary expenditure expansions in lessening the depth and duration of the recession, but also new ones, regarding the preferred mix of fiscal actions.
The expansionary impulses were considerably reduced during 2010 in Europe when the sovereign debt crisis, following the adjustments needed to bring fiscal solvency to Greece and Ireland, questioned the sustainability of the debt that would accumulate with the planned expenditure packages. In the U.S., instead, additional expenditures for infrastructures and credits for the automobile and the housing industries were legislated but concerns about the magnitude of the debt emerged. Beside the long-run sustainability of deteriorating fiscal positions, questions concerning the inflation consequences and the long run crowding-out effects of the debt accumulation were asked with increasing frequency.
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Fiscal policy, pricing frictions and monetary accommodation
