DP599 Trigger Points and Budget Cuts: Explaining the Effects of Fiscal Austerity

Author(s): Giuseppe Bertola , Allan Drazen

Publication Date: December 1991

Keyword(s): Consumption Smoothing , Stabilization , Sustainability

JEL(s): E21 , E62

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP599.asp

We present and analyse an optimizing model which explains the counter-intuitive effects of fiscal policy in terms of expectations. If government spending follows an upward-trending stochastic process, which the public believes may fall sharply when it reaches specific `target points', then optimizing consumption behaviour and simple budget constraint arithmetic imply a non-linear relationship between private consumption and government spending. This theoretical relation is consistent with the experience of several countries.