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Austerity is a set of economic policies implemented with the aim of reducing government budget deficits. Policies grouped under the term 'austerity measures' may include spending cuts, tax increases, or a mixture of both, and may be undertaken to demonstrate the government's fiscal discipline to creditors and credit rating agencies by bringing revenues closer to expenditures.
In most macroeconomic models austerity measures generally increase unemployment as government spending falls, reducing jobs in the public and/or private sector. Meanwhile, tax increases reduce household disposable income, thus reducing spending and consumption.
Since government spending contributes to the Gross Domestic Product (GDP), reducing the spending may result in a higher debt-to-GDP ratio, a key measure of a country's debt burden.
When an economy is operating at near capacity, higher short-term deficit spending (stimulus) can cause interest rates to rise, resulting in a reduction in private investments, which in turn reduces economic growth. In the case of excess capacity, however, the stimulus may result in an increase in employment and output.
A historical example in which austerity measures failed was in the aftermath of the Great Recession, where many European countries implemented such policies: unemployment rose to higher levels and debt-to-GDP ratios increased, despite reductions in budget deficits (relative to GDP).