Economist and Nobel laureate Paul Krugman argues that, according to the Keynesian model, cutting government spending or raising taxes has contraction effects on aggregate demand in the short term. This is because spending cuts have a large negative impact on real GDP ( Real NI).
As seen from the diagram, E3 represents the full-employment equilibrium, where full capacity output Yf is achieved without inflation. E2 represents the equilibrium without austerity measures. When the government cut spending, i.e. G decreases, the AD will shift to the left from AD2 to AD1, where the equilibrium E1 shows that the economy is operating far below its full capacity Yf. Government spending cuts lead to lower aggregate demand, for example, public sector pay freezes reduce consumer spending. Public sector job cuts lead to higher unemployment. Unemployment becomes a serious problem as huge resources are unused in this recession state of economy.(eg. Greece and Italy). Therefore instead of bringing the economy to E3, the austerity measures can only make the situation worse, causing serious unemployment issues and the NI to decrease from Y2 to Y1.
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Low Consumer Confidence-encourages higher saving and less spending.
Austerity encourages higher saving and less spending. In a recession there will be rising unemployment and therefore a fall in consumer confidence. This will cause a rise in the savings ratio. In other words, people will spend less of their disposable income and save more leading to a bigger fall in AD. If confidence remains very low for a long time then it will be difficult for the govt to increase AD. For example, if the govt cut income taxes this would increase disposable income, but if confidence was low people would not be willing to spend any extra and the economy would remain in a recession.
Example
In Greece, unemployment has soared to over 21%, fuelling social unrest that has sometimes turned deadly. In 2011 and 2012, riots have erupted frequently and the country's near-daily strikes and demonstrations have shut down schools, airports, train stations, ferries and harmed medical services.