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Lecture 6
Fiscal Policy and Goods Market Equilibrium
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Consumption and Saving

1. Effect of changes in current income

2. Effect of changes in expected future income
3. Effect of changes in wealth
4. Effect of changes in real interest rate
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Consumption and Saving

5. Fiscal policy
▪ Affects desired consumption through changes in current and expected
future income
▪ Directly affects desired national saving,
Sd = Y – Cd – G

a) Government purchases
b) Taxes
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Fiscal policy
a) Government purchases (temporary increase)
▪ Higher G financed by higher current taxes reduces after-tax income, lowering desired consumption
▪ Even true if financed by higher future taxes, if people realize how future incomes are affected
▪ Since Cd declines less than G rises, national saving
(Sd = Y – Cd – G) declines
▪ So government purchases reduce both desired consumption and desired national saving

b) Taxes
▪ Lump-sum tax cut today, financed by higher future taxes
▪ Decline in future income may offset increase in current income; desired consumption could rise or
fall
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Fiscal policy

▪ The government’s current-period budget constraint:

G =T + B

▪ The government’s future-period budget constraint:

G'+(1 + r)B = T '

▪ The government’s present-value budget constraint:

G' T'
G+ =T +
1+ r 1+ r
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Ricardian Equivalence

• Key equation: The consumer’s lifetime tax burden is equal to the consumer’s share of
the present value of government spending – the timing of taxation does not matter
for the consumer.

t' 1 G' 
t+ = G + 
1+ r N  1+ r 
Ricardian equivalence proposition
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▪ If future income loss exactly offsets current income gain, no change in

consumption
▪ Tax change affects only the timing of taxes, not their ultimate amount (present
value)
▪ In practice, people may not see that future taxes will rise if taxes are cut today;
then a tax cut leads to increased desired consumption and reduced desired
national saving
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Ricardian Equivalence with a Cut in Current Taxes for a Borrower

▪ Assume: a current tax cut ∆t<0

▪ Increase in taxes in the future, as the
government must pay off the current debt:
-∆t(1+r)>0
▪ Lifetime income we remains unchanged
▪ The budget constraint is unaffected.
▪ The endowment point shifts from E1 to E2.
▪ The consumer still chooses point A.
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Ricardian equivalence across generations

• What if the higher future taxes are to be paid by future generations?

▪ Then people might consume more today, because they wouldn’t have to pay
the higher future taxes

▪ If people care about their children, they’ll increase their bequests to their
children so their children can pay the higher future taxes

▪ After all, if people wanted to consume at their children’s expense, they could
have lowered their planned bequests
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Departures from Ricardian equivalence

• The data show that Ricardian equivalence holds sometimes, but not
always

▪ It certainly didn’t hold in the United States in the 1980s, when high government
deficits were accompanied by low savings
▪ It did seem to hold in Canada and Israel sometimes
▪ But overall, there seems to be little relationship between government budget
deficits and national saving
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Departures from Ricardian equivalence

• Application: How consumers respond to tax rebates

▪ The government provided tax rebates in recessions of 2001 and 2007-2009, hoping
to stimulate the economy

▪ Consumers did not increase spending much in 2001, when the government
provided a similar tax rebate (Shapiro and Slemrod).

▪ Even though consumers originally saved much of the tax rebate, later they
increased spending and increased their credit-card debt (Agarwal, Liu, and
Souleles).
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Departures from Ricardian equivalence

• Application: How consumers respond to tax rebates

▪ Younger people, who were more likely to face binding borrowing constraints,
increased their purchases on credit cards the most of any group in response to the
tax rebate.

▪ People with high credit limits also tended to pay off more of their balances and
spent less, as they were less likely to face binding borrowing constraints and
behaved more in the manner suggested by Ricardian equivalence.
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Departures from Ricardian equivalence

• Application: How consumers respond to tax rebates

▪ New evidence on the tax rebates in 2008 and 2009 was provided (Parker
et al.)
➢ Consumers spent 50%-90% of the tax rebates
➢ Inconsistent with Ricardian equivalence
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Departures from Ricardian equivalence

• What are the main reasons Ricardian equivalence may fail?

➢Borrowing constraints
▪ If people can’t borrow as much as they would like, a tax cut financed by higher future taxes
essentially lets them borrow from the government

➢Shortsightedness
▪ If people don’t foresee the higher future taxes, or spend based on rules of thumb about their
current after-tax income, they may increase consumption in response to a tax cut

➢Failure to leave bequests

▪ People may not leave bequests because they don’t care about their children, or because they
think their children will be richer than they are, so they will increase consumption spending in
response to a tax cut
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Summary : Determinants of Desired National Saving

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Goods Market Equilibrium

• The real interest rate adjusts to bring the goods market into equilibrium

❖Y = Cd + Id + G

• Alternative representation:
Since Sd = Y – Cd – G,

❖Sd = Id
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An Example: Components of Aggregate Demand for Goods

• When r=6%, Sd = Id, Y = Cd + Id + G. goods market equilibrium condition holds.

• When r=3%, Sd < Id, Y < Cd + Id + G
➢ Consumers save less, firms invest more when real interest rates are relatively low.
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Goods market equilibrium

Equilibrium where Sd = Id
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Goods Market Equilibrium

• Shifts of the saving curve
▪ Saving curve shifts right due to:
✓ a rise in current output,
✓a fall in expected future output,
✓a fall in wealth,
✓a fall in government purchases,
✓a rise in taxes (unless Ricardian
equivalence holds, in which case
tax changes have no effect)
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Shifts of the saving curve

Example: A decline in desired saving

▪ Temporary increase in government

purchases shifts S left
▪ Result of lower savings: higher r,
causing crowding out of I
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Goods Market Equilibrium

• Shifts of the investment curve
▪ Investment curve shifts right due to:
✓ a fall in the effective tax rate
✓a rise in expected future marginal productivity of capital

❖ Result of increased investment:

higher r, higher S and I
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Key Diagram: The saving–investment diagram

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Takeaway
• Fiscal policy
• Ricardian equivalence
• Departures from Ricardian equivalence
• Goods market equilibrium