Expansionary effects of fiscal consolidation: The role of expectations andinterest rates in the case of Denmark

The Danish fiscal consolidation of the early 1980s has received much schola rly attention because if was followed by an expansion of demand and output. The expansion of private consumption so far has been attributed to the exp ectations of future lower tax burdens This article analyzes the outcome fro m a different perspective, suggesting that the decline in interest rates an d also some degree of substitutability between private and public consumpti on played a crucial role in boosting private consumption. Ii shows that muc h of the consumption puzzle found in previous studies vanishes once the int erest rate is included as an explanatory variable This result is important from an economic policy perspective because it relates the expansionary eff ect to a variable that, in contrast to expectations about future tax cuts, is directly observable and more closely linked to the actual policy stance.