Fiscal Consolidations and Heterogeneous Expectations

We analyze fiscal consolidations using a New Keynesian model where agents have heterogeneous expectations and are uncertain about the composition of consoidations. Heterogeneity in expectations may amplify expansions, stabilizing thus the debt-to-GDP ratio faster under tax based consolidations, in the short run. In the medium to long-run though, the magnitude of the consolidation may favor spending cuts as long as agents anticipate tax increases. Interestingly, wrong beliefs about the composition of fiscal consolidation may improve or harm the effectiveness of the latter, depending on the degree of heterogeneity.