I have been telling you about the fiscal cliff for some time. Other people are starting to seriously worrying about it. An analysis from Reuters makes an interesting point about the output effects of government purchases and taxes. Until the Great recession, a one dollar of government cuts reduced output by only 50 cents. The reason was that, to stimulate economy, central banks would typically simultaneously lower interest rates. We will talk about in in more details when we discuss the IS-IC model in chapter 9.
But now interest rates are at or near zero and central banks cannot reduce them. In other words, when the fiscal cliff comes, central banks will not be able to stimulate the economy and a dollar government cut will reduce output by an estimated 0.9-1.7 dollars. The fiscal cliff involved a combination of tax increases and spending cuts of around 4% of US GDP. This means that the US economy, which is predicted to grow at 2% if the cuts are avoided, will shrink significantly.
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