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Harvard University Professor Alberto Alesina has returned to the debate on budget deficits, austerity and growth.The implication is that austerity -- cutting the budget deficit, not expanding it -- may well be the right policy in a recession.Alesina's theory rests on two conceptual pillars.Spending cuts, on the other hand, signal lower taxes in the future, and thus stimulate investment and consumption.Austerity, by stopping the growth of debt, can bring about a "sizable reduction" in interest rates, and thus enable increased investment.In this case, low interest rates will be the result not of austerity, but rather of monetary expansion.The same argument explains why, on Alesina's view, it is better to reduce the deficit by cutting spending than by raising taxes.However, Keynes' expectational map was very different from Alesina's.If the government increases its spending on public works, this will not only employ more workers directly, but also increase the demand for automobiles, so the output of the economy grows by more than the government's extra spending, thus reducing the deficit.Alesina says that an announced reduction in public spending signals to businesspeople that they can expect lower taxes tomorrow, and therefore will spend more today.
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