Less government - More wealth? On the macroeconomics of a smaller public sector in Europe

In this paper, we analyze the reactions of European economies to a fiscal policy strategy aiming at diminishing the public sector. Within the framework of the MSG3 model, a macroeconomic model of the world economy, we perform several simulation experiments to explore the effects of reducing government expenditures permanently in different phases of the business cycle. For this purpose, we combine the fiscal contraction with negative and positive, Euro Area-wide and global, supply and demand shocks. It turns out that adverse Keynesian effects on output and employment tend to be mostly weak and short-lived, whereas long-run effects on output and employment are favorable. Due to these long-run effects, the fiscal contraction policy raises welfare as measured by an asymmetric quadratic objective function. The size of these welfare effects depends on the initial situation in a non-trivial manner.