How does fiscal consolidation affect the economy?
The research presented below from the IMF from October 2010:
finds that fiscal consolidation typically reduces output and raises unemployment in the short term. At the same time, interest rate cuts, a fall in the value of the currency, and a rise in net exports usually soften the contractionary impact.
Consolidation is more painful when it relies primarily on tax hikes; this occurs largely because central banks typically provide less monetary stimulus during such episodes, particularly when they involve indirect tax hikes that raise inflation. Also, fiscal consolidation is more costly when the perceived risk of sovereign default is low. These findings suggest that budget deficit cuts are likely to be more painful if they occur simultaneously across many countries, and if monetary policy is not in a position to offset them. Over the long term, reducing government debt is likely to raise output, as real interest rates decline and the lighter burden of interest payments permits cuts to distortionary taxes.
(full pdf version embedded below)